Nnn REIT, Inc. Q2 FY2024 Earnings Call

Greetings, and welcome to NNN REIT Inc. Second Quarter 2024 Earnings Call. At this time all participants are in listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Mr. Steve Horn, Chief Executive Officer of NNN REIT. Sir, you may begin.

Thanks, Holly. Good morning, and welcome to NNN REIT's second-quarter 2024 earnings call. As usual, joining me on the call is Chief Financial Officer, Kevin Habicht. As the press release reflects, the company's consistent performance carried through the second quarter and produced strong results, including high occupancy and in-line acquisitions volume driven by our proprietary tenant relationships. We are in a position to continue enhancing shareholder value as we move deeper into 2024 and start setting up for 2025. Highlights of the second-quarter financial results emphasize our continuous effort to actively manage the portfolio with data analytics and experience. The portfolio of 3,548 freestanding single-tenant properties continues to perform exceedingly well, maintaining high occupancy levels of 99.3%, which remains above our long-term average of roughly 98%. Knowing the acquisition pipeline, market conditions, and portfolio performance, NNN feels comfortable about increasing the midpoint of core FFO per share guidance by $0.02 to $3.30. The leasing department continued the strong start of the year by identifying and executing with QSR tenants, achieving a 158% recapture rate from the prior rent during the quarter, which brings year-to-date recapture to 102%. This recapture is above historical levels of approximately 70%. Just to be clear, NNN does try hard not to give TI dollars to 'buy up rent'. Currently, NNN only has 26 vacant assets in the portfolio, which is a testament to working with relationship tenants to maximize value for shareholders. During the quarter, we also sold 14 properties, 11 of which were income-producing, raising $67 million of proceeds to be reinvested into new acquisitions. Over the course of the year, NNN sells assets defensively and proactively, but overall, we target a blended disposition cap rate to be about 100 basis points lower than the deployment of capital pricing. Year-to-date, NNN has sold $85 million of assets, resulting in an increase of the disposition guidance lower end to $100 million from $80 million. Staying on the portfolio, I'd like to mention with regard to 2024 lease expirations, which we originally had about 90 heading into the year, is all but wrapped up, and we landed right near our historical average of 85% for renewals. Now the asset management department is turning its attention to 2025 renewals, which I see no cause for concern based on the makeup of assets and tenants. On to acquisitions. During the quarter, we invested $110 million in 16 new properties at an initial cash cap rate of 7.9%, a potential yield that, if we are required to straight line it, would be about 8.9%, with an average lease duration of over 16 years. 100% of the deals involved relationship tenants with whom we do repeat business, creating barriers for competitors to solidify NNN's deals. Regarding the acquisition pricing environment, last quarter, our initial acquisition cap rate was approximately 10 basis points tighter than the first quarter of 2024 and 70 basis points wider than the second quarter of 2023. My expectation is that NNN's cap rates for targeted acquisitions will remain in the mid to high 7s for the remainder of the year. This assumption results from, firstly, the third-quarter transaction pricing being largely locked in; secondly, the run-up in equity prices in the sector creates marginally better cost of equity; and lastly, the market is starting to price in short-term rate cuts. Knowing our current pipeline and dialogue with our partners, we remain comfortable with our ability to meet and hopefully exceed our 2024 acquisition guidance of $400 million to $500 million, primarily via the direct sale leaseback on our long-duration triple net lease format, which is much more landlord-friendly than the 1031 market deals. Our balance sheet remains one of the strongest in the sector with a leading 12.6-year average debt maturity, and our next debt maturity isn’t until the fourth quarter of 2025. The credit facility has plenty of dry powder with a quarter-end balance of approximately $12 million, down from $132 million at year-end, and we just increased the capacity to $1.2 billion. NNN is well positioned to fund our 2024 acquisition guidance and beyond. With that, let me turn the call over to Kevin for more color and detail on the quarterly numbers and updated guidance.

Thanks, Steve. As usual, I'll start with our typical cautionary statement that we will make certain statements that may be considered forward-looking under federal securities law. 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, so headlines from this morning's press release report quarterly core FFO results of $0.83 per share for the second quarter of 2024, and that's $0.03 or 3.8% over year-ago results of $0.80 per share. AFFO results were $0.84 per share for the second quarter, which is $0.04 or 5% higher than year-ago results. Second-quarter results did include $2.1 million of lease termination fee income, which is relatively high for us and that compares with $300,000 in the second quarter of 2023. And as you might recall, we reported $4.2 million of lease termination fee income in the first quarter of this year. So for the first half, we're reporting $6.3 million of lease termination fee income for the first half of 2024 versus $2 million for the first half of 2023. If you look back over the last five years, we have averaged $3 million of annual lease termination fee income. So all that to say, this year is running well above normal. But even without that incremental income overall, it was a good quarter and in line with our expectations. As Steve mentioned, occupancy was 99.3% at quarter-end, G&A expense was $11.8 million for the quarter and represents 5.4% of revenues for the quarter and 5.6% of revenues for the first half, which is in line with our guidance. I'll push here for folks to also think about G&A as a percentage of NOI, which for us was 5.6% in the second quarter. I believe this highlights one of the advantages net lease companies enjoy versus what I’ll call gross lease companies in that more of our revenue drops to the bottom line, which supports total shareholder returns. Our AFFO dividend payout ratio for the first half of 2024 was 67.1%, resulting in approximately $101 million of free cash flow for the six months after the payment of all expenses and dividends. Incorporating the increased dividend we recently announced, we currently anticipate this free cash flow amount coming in at approximately $195 million for the full year 2024, which corresponds to about a 68% payout ratio for the year. We ended the quarter with $837.6 million of annual base rent in place for all leases as of June 30, 2024, which takes into account all acquisitions and dispositions completed during the quarter. As Steve mentioned, we did increase our 2024 guidance on both the bottom and top end by $0.02 a share, with a new range for core FFO per share of $3.27 to $3.33 per share. The underlying assumptions did not notably change. G&A acquisition volume is remaining the same, as Steve mentioned, with a small increase in disposition volume expectations to a new guidance of $100 million to $120 million for the year. Switching over to the balance sheet, there was a small amount of equity issuance in the second quarter at a little over $42 per share, generating $13 million in net proceeds. With a big thanks to our supportive bank group in April, we completed a recast of our bank credit facility, increasing the capacity by $100 million to $1.2 billion and extending the term to 2028. There were no material changes to the bank line's terms. In May, we issued $500 million of 5.5% notes due in ten years. In June, we paid off $350 million of 3.9% notes that came due on June 15. So, with this debt refinance activity, our weighted average debt maturity ticked up to 12.6 years at quarter-end, which will help us slow the refinance headwind that all companies are facing in the coming years. We maintain good leverage and have kept the balance sheet in a strong liquidity position with $1.2 billion of available liquidity at quarter-end. Maintaining our life capital market footprint, we funded nearly 79% of our $235 million of year-to-date acquisitions with free cash flow of $101 million and $86 million of disposition proceeds. For the full year 2024, based on our midpoint of our acquisition and disposition guidance, we should fund close to 68% of 2024 acquisitions with free cash flow and disposition proceeds. A couple of stats for the balance sheet: net debt to gross book assets was 41.6%; net debt to EBITDA was 5.5x at June 30; interest and fixed charge coverage was 4.2x for the second quarter. As a reminder, none of our properties are encumbered by mortgages. So we remain focused on working to appropriately allocate capital, ensuring we get what we believe are sufficient returns on equity, while controlling risk through property underwriting, and maintaining a sound balance sheet. Valuing equity adequately, whether that equity is produced by free cash flow, disposition proceeds, or new equity issuance, is essential to growing per-share results over the long-term and helps us avoid confusing activity with achievement. In closing, 2024 is tracking largely as expected for us, and we believe we're in a relatively good position to navigate any uncertainties as we continue to focus on growing per-share results. We are mindful this is a long-term, multi-year endeavor.

We will now open it up to any questions.

Can you just provide some updated color on the transaction market and kind of where cap rates have been trending thus far in the 3Q?

The overall market, my expectations, based on discussions with the acquisition team, is deal volume for current tenants is starting to pick up a little bit. The overall opportunity set is larger today than it was 60 days ago, which is positive. A couple of larger portfolios are starting to hit the market. As far as cap rates, as I mentioned in the opening statements, the third quarter is starting to get baked, and I’m seeing the cap rates in line with our second quarter. The timing of deals might fluctuate by 5 to 10 basis points, but generally aligns with our second quarter and is not as wide as our first quarter. For the remainder of the year, I project that what we observed in the second quarter will continue.

Can you share a little more color on the dispositions made in the quarter? You mentioned there were 11 income-producing assets. Perhaps just the rationale for the divestments. Additionally, could you discuss the depth of the buyer pool as well?

Yes, we sold 14 assets, 11 of which were income-producing. We had a couple of vacancies that over time, we decided it was better to sell them and redeploy into accretive acquisitions. It was primarily a mixture of defensive sales, with a few multi-tenant assets that are not core to the portfolio. Over a decade or so, we decided to exit these non-core assets as we do not think owning shopping centers is a good investment for a net lease company. We sold several properties that were highly desired by buyers willing to pay attractive cap rates.

This is Farrell Granath on behalf of Josh. I wanted to follow up on your comments about the termination fees that have been coming in, especially since the second quarter is elevated over historical levels. Are you noticing any trend, or are these discussions coming to you earlier? Are there specific categories these are falling under?

Not really any significant trends. However, I've noticed more lease termination fee income discussions recently, just through various notes and comments from other REITs. It’s hard to predict when these opportunities will arise as they involve at least three parties with competing priorities. The most recent quarter's largest chunk of lease termination fee income came from a property involved in condemnation, which allowed us to capture proceeds and a lease term fee. Nevertheless, it’s hard to project and I recommend focusing on our five-year average rather than trying to forecast these high levels into the future.

Are there any tenants from your top 20 list under surveillance, and those not on the top 10 or 20 list? Are you increasing any monitoring regarding performance levels?

We're always monitoring tenant performance. Those on the watch list get a bit more attention, but it’s a standard part of our operations. One of the tenants we've discussed regularly is a restaurant concept called 'Fishes', which continues to pay rent but is struggling to recover from the pandemic impacts. As for tenants outside our top 20 list, we feel better today about AMC, given recent successes in the box office and their refinancing activities. Other tenants we're monitoring closely include 'At Home' and 'Big Lots', which are facing challenges, as well as 'Badcock Furniture', which is in bankruptcy. Despite these worries, our current exposure remains manageable.

I'd like to discuss consumer trends, especially impacts on the low-end consumer and how that might affect your tenants. How are you assessing tenant health in context of today's consumer environment?

We analyze our properties across all industries. The data we have is from March, so it’s slightly outdated. Rent coverage ratios throughout the portfolio have generally remained stable. Coverage slightly declining from 3.5% or 3.25% isn't a significant concern. However, we do factor in potential consumer softness when underwriting assets in specific industries. Overall, low-end and mid-range consumers have held their ground within our portfolio, thanks largely to our business model, allowing tenants to self-select assets for sale under long-term commitments.

Are you seeing increased competition entering the market heading into the second half of 2024, particularly from private equity buyers who may have returned to the market?

Historically, we’ve been in a highly competitive market for over 20 years, with just the names of competitors changing. The banking market hasn't been as active lately as it was three years ago, so we haven't noticed many new entrants. Private equity remains largely on the sidelines regarding our target acquisitions, but competition remains tight across the board. Due to our repeated deals with our current tenant base, we have sufficient opportunities to meet our acquisition targets.

What does bad debt look like? I know you have 100 basis points in your guidance, but historically it's been between 30 and 50 basis points. Given Conn's bankruptcy and Walgreens store closures, do you expect any changes this year?

I appreciate you asking that question. We still assume about 100 basis points of rent loss each year as a standard, and we haven’t adjusted that in our projections. Therefore, at the moment, I don’t see anything unusual impacting our portfolio or cash flow. We expect to remain within our normal range for potential rent loss this year. Although the actual rent loss has typically been between 30 and 50 basis points, this year might touch a bit higher, but we feel confident about our situation.

Given the shares issued during the quarter, how are you thinking about share issuances going forward to build dry powder into 2025?

We don't need to issue any equity at this moment, as I've noted, over two-thirds of our acquisitions for this year can be funded solely through free cash flow and dispositions. This means we can choose to issue equity when it's appropriate and well-priced. Looking back at our history, we've issued around $60 million worth of equity over the last 18 months, so we’re cautious and strategic in our approach. No real need for equity right now.

Are there certain areas, sectors, or tenants where you're noticing the most opportunities for the remainder of the year?

As I examine our opportunity set, sectors like convenience stores are beginning to show increased activity, along with auto service. For our current portfolio, I’d lean towards family entertainment for opportunities, while not seeing much activity in car wash or QSR sectors recently.

Regarding guidance, what influenced the recent adjustments? The increase to disposition volume expectations was noted, but was the lease termination fee income anticipated when guidance was issued? Was the debt issuance in line with your expectations?

There weren’t many variables impacting our guidance adjustments. We typically start the year conservative, making room for potential upside, which has led us to raise guidance. We have seen more lease termination fee income than previously thought, but it’s difficult to predict timing. We dedicated some room for unexplored rent loss, helping to increase guidance by $0.02 based on the first half results. That’s the main factor driving the adjustment in guidance.

Looking at real estate expenses, we noticed a slight increase in the bottom end of expectations. Is that indicative of recent credit events that you discussed earlier in the call?

Yes, that’s correct. You can see our recent real estate expenses running around $2.5 to $2.6 million. We did increase the guidance range for the year from $9 million to $11 million to $10 million to $11 million. This reflects a marginal increase on the midpoint and aligns with our expectations without any significant changes in outlook.

In the context of investment activity for the remainder of the year, how are tenants responding to the decline in interest rates? Has this impacted the bid-ask spread in the net lease marketplace?

Overall, there has been a slight tightening in the bid-ask spread, driven by the combination of the equity run-up starting early July. Deals are being priced based on previous market conditions, and sellers are becoming more inclined to transact as they recognize the necessity of higher cap rates. The activity level of deals coming to market has picked up.

Could you touch upon bad debt guidance again? I know there's been a lot of news in the furniture sector. What is your exposure there and how are you thinking about those tenants?

Our primary exposure in the furniture sector is a company called Badcock, which accounts for 0.7% of our rent. They recently filed for bankruptcy but were purchased by Conn, a retailer we've not partnered with previously. The seller remains a guarantor on our lease, so we’ll have to see how that unfolds in the coming months. Although our rents are reasonable, we don't perceive significant risk at this point. Regarding our $1.68 AFFO in the first half of the year, would you remind us how much of that is one-time? I find the full year guidance a bit conservative. Specifically, how much of that amount one-time income should we avoid annualizing? The significant non-recurring income in our first-half figures is chiefly $6.2 million from lease termination fees. This translates to roughly $0.03 to $0.04 per share this year. Normally, we expect about $1.5 million in lease termination fees. So, it might imply about $4M to $4.5M in unusually high lease terminations this year, making a portion of that first half non-recurring.

I appreciate everyone taking the time to join us today. NNN is well positioned for the remaining year ahead. Enjoy the rest of your summer, and we look forward to seeing you as conference season kicks off.

This concludes today's call. You may disconnect your lines at this time. Thank you for your participation.