Earnings Call Transcript - NNN Q1 2023

Operator, Operator

Greetings, and welcome to the NNN REIT First Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode, and 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, CEO of NNN REIT. Sir, you may begin.

Steve Horn, CEO

Thanks, Ali. Good morning, and welcome to the inaugural NNN REIT First Quarter 2023 Earnings Call. Joining me on this call is Chief Financial Officer, Kevin Habicht. As this morning’s press release reflects, NNN’s performance in the first quarter produced 3.9% core FFO growth along with acquisitions, slightly over $155 million with a 7% initial cash yield. In addition, our portfolio retained a high occupancy of 99.4%, which I attribute to the upfront due diligence on property acquisitions and the continuous portfolio management that NNN does every day. But before we continue with the operational performance, I want to address the name change, which I’m excited about. First, as I stated in the press release, the change does not signal a strategy shift with acquisitions, balance sheet management with a deliberate and consistent NNN approach. We felt it was time to take advantage of the NNN brand. The reality is NNN is what we are called by our circle of investors, peers, and clients every day. In addition, our website and emails use the NNN REIT brand. Therefore, the change makes NNN even more consistent within our sector. Turning to the highlights of the first quarter financial results, our portfolio of 3,449 freestanding, single-tenant retail properties continues to perform exceedingly well. As I stated earlier, occupancy ended at 99.4% for the quarter, which is above our long-term average of 98%. Occupancy remained flat from year-end. At the quarter-end, NNN only had 20 vacant assets, which is one less than year-end, a product of our leasing department enjoying a high level of interest from a number of strong national and regional tenants in our vacancies. In addition, 91% of our leases that were up for renewal during the quarter exercised an extension. I’m sure we’ll cover more on the credit watch list in the Q&A, but I want to add a bit more color. There were some large names that filed for bankruptcy, yet our portfolio is still performing at high levels, and we expect that trend to continue. One of the recent filings was Bed Bath & Beyond, for which NNN currently owns three of their assets with an average rent of $13 per square foot. We’ve received a lot of inbound interest on these assets because of the quality of the real estate. So I expect that when the time comes to release the assets, we’ll have a superior recovery rate in a timely manner. As I mentioned earlier, the average occupancy from NNN since 2003 has been 98%. So, the portfolio has stood the test of time through the Great Financial Crisis and COVID. Regarding acquisitions, we’ll continue to be prudent in our underwriting, and NNN is afforded the luxury to continue to be selective. We acquired 43 new properties in the quarter for approximately $155 million, with an initial cap rate of 7% and an average lease duration of 19 years. Almost all of our acquisitions this past quarter were sale-leaseback transactions. That’s a result of the dedicated effort of our NNN acquisitions department. NNN prides itself on maintaining a relationship-based business model, which allows us to repeat programmatic business. With regard to the acquisition pricing environment, the last quarter's initial cap rate of 7% is approximately 40 basis points wider than the fourth quarter of 2022. As I mentioned during the February call, we were seeing cap rates steadily increase. But now, as we sit here at the beginning of May, the cap rate increases are starting to plateau. What I mean is that the rate of increase is definitely slowing down. Thus, I’m not expecting another 40 basis points for the second quarter of 2023. This is resulting in NNN seeing that cap rates are starting to hit a glass ceiling, assuming the macroeconomic environment settles down. During the quarter, we also sold six properties that generated nearly $12 million in proceeds, which will be reinvested in new acquisitions. The dispositions consisted of three vacant assets and three income-producing assets at a 6.6% rate. I expect disposition activity to increase in the second quarter, and we are keeping our disposition guidance unchanged for the year. In summary, the occupancy rate, leasing activity, and the relationship-based sale-leaseback acquisition volume continue to validate our consistent long-term strategy of acquiring well-located parcels leased to strong regional and national operators at reasonable rent while maintaining a strong and flexible balance sheet. As I stated earlier, NNN is on solid footing as we are a quarter into 2023. With that, let me turn the call over to Kevin for more color and detail on our quarterly numbers.

Kevin Habicht, CFO

Okay, Steve, thank you. And as usual, I’ll start with the cautionary statement. We will make certain statements that may be considered to be forward-looking statements 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, headlines from this morning’s press release report quarterly core FFO results of $0.80 per share for the first quarter of 2023, which is up $0.03 or 3.9% over year-ago results of $0.77 per share, and that was flat with prior fourth quarter results. Today, we also reported that AFFO per share was $0.82 for the first quarter, and that’s also up $0.03 per share or 3.8% over Q1 2022 results. As can be seen in the footnote on page 1 of the press release, as well as the detailed deferred rent repayment schedule on page 13, the accrual basis deferred rent repayments have now been virtually fully repaid and will not create any significant noise in our AFFO number going forward. The scheduled cash basis deferred rent repayments continue to taper off materially in 2023, as can be seen again in the details provided on page 13 of the press release. This slowdown creates approximately a $5.8 million or $0.03 per share headwind for the full year, which we previously noted and is baked into our 2023 guidance. One last note on first quarter results: we received $1.7 million in lease termination income, which is higher than normal compared to $1.0 million in Q1 of 2022. Overall, it was a good quarter, in line with our expectations. Moving on, our AFFO dividend payout ratio for the first quarter of 2023 was approximately 67%, which created approximately $49 million of free cash flow, after the payment of all expenses and dividends for the quarter. This free cash flow funded 31% of our total acquisitions in the first quarter, which is about half of the equity needed for those acquisitions, assuming we maintain a balance sheet at roughly 60% equity and 40% debt on a gross book value basis. Occupancy was 99.4%, as Steve mentioned, at quarter-end, and that’s flat with year-end 2022. G&A expense was $12.25 million for the quarter, representing about 6% of revenues, but our midpoint guidance for this line item is still $44 million for the full year 2023, which would put G&A closer to about 5.5% of revenues for the year. We ended the quarter with $782 million of annual base rent in place for all leases as of March 31, 2023. Today, we did not change our 2023 guidance, which we introduced in February. First quarter results might suggest that we have the opportunity to be at the higher end of the guidance range, but we will revisit any guidance changes when we report second-quarter results. The 2023 guidance and the key supporting assumptions are on page 7 of today’s press release. Switching over to the balance sheet, we maintain a good leverage and liquidity profile of roughly $900 million in liquidity. The first quarter was fairly quiet in terms of capital markets activity. We issued $17 million of equity in the first quarter, executing trades around the $46 per share level. After a few years of nearly no usage of our $1.1 billion bank line of credit, we began to utilize it a bit in 2023, which was part of our plan to navigate this rockier interest rate and capital market environment. Our weighted average debt maturity is about 13 years, including that bank line. All of our debt outstanding is fixed rate, with the exception of the $209 million on our bank line, which represents about 5% of our total debt. A couple of metrics: net debt to gross book assets was 40.4%, flat with year-end. Net debt-to-EBITDA was 5.3 times as of March 31st. Interest coverage and fixed charge coverage was 4.7 times for the first quarter of 2023. We are in very good shape to navigate the elevated economic and capital market uncertainties and to continue growing per share results, which we view as the primary measure of success. And with that, we will open it up to any questions. Ali?

Operator, Operator

Thank you. Our first question is coming from Spenser Allaway with Green Street.

Spenser Allaway, Analyst

You mentioned in your prepared remarks that the rate of cap rate increases has slowed. But can you just comment broadly on the different retail industries, are there any segments that stand out as continuing to have a wider bid-ask spread? So, cap rates haven’t moved just quickly. And then to the contrary, any industries that have seen cap rates move faster?

Steve Horn, CEO

Yes. The cap rates during the second half of last year increased at a significant clip. What we’re finding is that in the second quarter, specifically asking about segments, it is whatever our portfolio includes; that’s the segment I’m really speaking of. Whether it’s quick service restaurants, convenience stores, or auto service, those are typically where we’ve had the most volume recently, including large regional operators and non-investment-grade tenants. Yes, we are currently seeing a slight plateau in the cap rates; they are at acceptable levels. But we picked up 40 basis points and I foresee that expanding into the range of 20-30 basis points for the second quarter. Moving out to the third quarter, it’s a bit too early for precise pricing. But assuming the economy remains stable, I think we’re nearing the top of it.

Spenser Allaway, Analyst

Okay. That’s helpful. The cap rate on the dispositions seemed low for the second quarter in a row. Is there anything unique driving that lower than prior quarters? And is there a reason to think that could continue on future dispositions this year?

Steve Horn, CEO

The dispositions: we’re not changing our guidance for 2023. I expect to meet that guidance range. It was more of a timing issue, lower in the fourth quarter and the first quarter, but the stars are aligning, and I expect the second quarter to increase in pace a bit. As for our dispositions this quarter, again, the three vacancies and the 6.6% cap rate resulted from two defensive sales. One was a distressed rental asset we sold, and the other was an obsolete gas station. The third was an opportunistic sale where the buyer valued the property more than we did.

Operator, Operator

Our next question is coming from Joshua Dennerlein with Bank of America.

Joshua Dennerlein, Analyst

Could you remind us what the bad debt amount is assumed in guidance and how the Bed Bath & Beyond bankruptcy falls within that range?

Kevin Habicht, CFO

Yes. Sure. This is Kevin. Yes. In our guidance, as we have for several years, we assumed 100 basis points of rent loss and didn’t really utilize any of that in the first quarter. Specifically regarding Bed Bath & Beyond, our stores haven’t been closed or placed on the rejection list. Thus, we anticipate they will continue to pay rent until that changes, if and when it does. At the moment, we’re not experiencing any significant levels of bad debt.

Joshua Dennerlein, Analyst

Okay. Interesting. So, they’re not on the closure list?

Kevin Habicht, CFO

Correct. Yes. They’ve announced, I think, 480 total stores, including 360 Bed Bath and 120 buybuy BABY, and our stores are not on that list.

Joshua Dennerlein, Analyst

Okay. Good color. I read the 10-Q that came out this morning, and there’s another tenant in bankruptcy. Could you update us on that tenant, the assets and maybe what the trends are compared to the market?

Kevin Habicht, CFO

Yes. We only have two in bankruptcy. One is Bed Bath, which we discussed, and the other is Regal Cinema. That just involves one property, and we’ll see where that goes. They’re still paying rent, but we will negotiate that. Whether that survives or not, time will tell, but it's very small in the big picture.

Operator, Operator

Our next question comes from Eric Roth with Citi.

Eric Roth, Analyst

Thanks. Good morning. Starting with the guidance question, what takes you from that current run rate of $0.82 in the first quarter down to $0.80 for the rest of the year? I think you have lease termination income, but it would seem like there are other factors bringing you down.

Kevin Habicht, CFO

Yes, not really. I think as I noted in my prepared remarks, we’re clearly tracking for the high end of our guidance range, and there was a little internal discussion about whether we would consider revising our guidance. But we’re measured and deliberate in our approach. We decided to defer that decision to the second quarter. I did note that there’s $0.01 of unusual one-time income from the lease termination in Q1 that helped our results. We like where we stand and hopefully, with time, we can revise our guidance upward, which has occurred from time to time over the years. But that’s how we approached it this time.

Eric Roth, Analyst

You mentioned that the cap rate is reaching a glass ceiling around 7%. You indicated it might expand by about 20-30 basis points. At that low-7 cap rate, how do you view your ability to create value at that level, considering your cost of capital? I observed that you didn't raise much on your ATM in the first quarter, but that may have been more related to timing.

Steve Horn, CEO

Yes. I’ll address that. Regarding cap rates hitting that ceiling, we expect the second quarter to expand off our 7% cap rate as stated in my earlier remarks. The third quarter is a bit too early to project. But we are prepared to deploy funds at around the 7.25% to 7.3% range. Kevin can elaborate further as it relates to our cost of capital.

Kevin Habicht, CFO

I won’t delve into all the details now, but we typically burden our cost of equity at around 8.5% for capital deployment. This targets a return hurdle we’ve set internally when considering new investments. What this translates to is a weighted average cost of capital, including, in the low 7s. Thus, we believe it's necessary to generate acceptable returns for NNN shareholders. Others may take a different view regarding their cost of equity, but our approach has helped us remain disciplined over the years. To summarize, we haven't typically targeted a substantial spread above our cost of capital, primarily because we burden our equity with a higher rate than most companies. As such, we usually do not define a significant spread above our cost of capital.

Operator, Operator

Thank you. Our next question is coming from Rob Stevenson with Janney.

Rob Stevenson, Analyst

Good morning, guys. Steve, back to the cap rate commentary that you were making before. How much does that defer the movement between sale-leasebacks versus the one-off and small portfolios that may be more sensitive to issues with banks these days?

Steve Horn, CEO

Hey Rob, good question. We don’t operate in what we call the 1031 market, which includes one-off transactions. We have a dedicated acquisition professional focused on finding unique opportunities. However, our day-to-day operations primarily involve sale-leasebacks. The sophisticated clients have recognized that the lending environment is challenging in the middle market and are migrating towards sale-leasebacks. This has allowed for cap rate expansion. The 1031 market experiences more competition, where cash buyers aren’t as sensitive to the current bank lending market. Hence, their cap rates haven’t shifted as much. That said, if you’re in the investment-grade market purchasing deals at high-4s or low-5s, there’s been a significant movement in cap rates due to their historically low starting point over the last few years. Currently, in the sale-leaseback market, we continue to see increases for the second quarter, just at a slower pace.

Rob Stevenson, Analyst

Okay. How deep is that buyer pool today? I mean, if the seller doesn’t like your price, do you have 25 buyers behind you who are willing to match that price? Or has the buyer pool for these sale-leaseback transactions thinned out given rates and other issues?

Steve Horn, CEO

The narrative remains consistent. I’ve been with NNN REIT for 20 years, and we've always encountered a highly competitive market. While there are fewer buyers currently reliant on secured loans, the competition remains fierce. No one is displacing assets; it’s all market pricing. If a seller isn't satisfied with my pricing, there’s someone ready to step in at that price.

Kevin Habicht, CFO

Rob, it's interesting to note that today, the costs are quite uniform. Bank lines are about 5.5%, 10-year debt around that figure, and 30-year debt isn’t much higher. The debt decision hinges on the interest rates forecast for the next 2-4 years. Over the past few years, we secured long-term debt and extended our average maturity significantly. We’ve opted to utilize our bank line, which had been virtually unused, to navigate this interest rate cycle and observe how it plays out over the coming year before making any long-term commitments. I should clarify that we typically don’t offer guidance on capital market activities, and I reserve the right to change my mind.

Operator, Operator

Our next question is from Wes Golladay with Baird.

Wes Golladay, Analyst

Are you observing any signs that tenants will pause expansion due to macro uncertainty?

Steve Horn, CEO

What we’re currently seeing is that our development pipeline is remarkably high compared to historical standards. Thus, we don’t see a slowdown in their expansion plans concerning individual sites. However, it’s not the economic uncertainty affecting their customers; rather, it stems from the debt lending situation. The M&A activity has notably decreased. Tenants are currently engaging in smaller bolt-on acquisitions instead of large-scale deals. Fortunately, we are in a position where we remain unaffected by the need for major wins, as our target pool is extensive enough to meet our objectives.

Wes Golladay, Analyst

Okay. Kevin, I’d like to revisit your comments on the weighted average cost of capital. You mentioned it was low-7s. How do you determine if that aligns with your current acquisitions? Have you historically sought a spread above that, or do you simply assess that you’re achieving better quality while the overall quality mix is priced at your weighted average capital?

Kevin Habicht, CFO

I know this is somewhat counterintuitive, considering the vernacular of our industry regarding spreads above our cost of capital. The way many derive a spread is by underestimating their required equity return. In our pitch book, we emphasize that burdening our cost of equity today results in an approximate 8.5% return. This influences how we deploy capital. Essentially, we don’t necessitate a considerable spread over our cost of capital since our higher burdened equity rate adequately compensates our shareholders. Thus, we generally lack a substantial spread above our cost of capital. However, we consistently prioritize being disciplined, which has served us well. About two years ago, our weighted average cost of capital was closer to 6%. As market conditions changed, we raised our equity hurdle. Currently, our target is low-7s, which we believe sufficiently compensates our shareholders. Moreover, when sourcing capital, we often acquire it irrespective of immediate necessity, knowing we will utilize it eventually. This approach, although distinct, has been successful for us over the years.

Operator, Operator

Thank you. Our next question is from John Massocca with Ladenburg Thalmann.

John Massocca, Analyst

Building on Wes' initial question: when evaluating tenant investments, what’s the overall breakdown between expansion and potential refinancing?

Steve Horn, CEO

Currently, the focus leans heavily towards expansion. It's still early in the year, and we aren’t witnessing significant refinancing pressures among our tenants. Most choose sale-leaseback financing because it enables them to invest that equity back into operations, realizing higher margins from their goods or services rather than tying up funds in real estate appreciation. Our capital deployment primarily revolves around M&A financing and new store developments.

John Massocca, Analyst

You touched a bit on Bed Bath & Beyond, but more generally, what is the demand like for vacant assets, vacant boxes, etc.?

Steve Horn, CEO

From our current 20 vacant assets, we have activity surrounding a little over half of them right now. This is pleasantly surprising, as typically a vacant asset isn’t our prime real estate. Yes, we're witnessing some movement from smaller regional or mom-and-pop operators taking on some of our vacant spaces.

John Massocca, Analyst

How does that activity compare to pre-pandemic or earlier years?

Steve Horn, CEO

Activity levels are definitely higher currently; we’re seeing increased movement concerning our vacant assets. Our primary goal is re-leasing. However, after a certain period, it's impractical to retain vacancies. We prefer selling them at a reasonable price and then reinvesting those funds into acquisitions.

Operator, Operator

Thank you. We have reached the end of our question-and-answer session. I will now turn the call back over to Mr. Horn for closing remarks.

Steve Horn, CEO

Thank you, Ali. NNN is in a great position heading into the second quarter. I look forward to it. Thanks for joining us this morning. We also look forward to seeing many of you in person during the upcoming conference season, specifically ICSC and NAREIT. Thanks for joining.

Operator, Operator

Thank you. This concludes today’s conference, and you may disconnect your lines at this time. We thank you for your participation.

Steve Horn, CEO

Thanks, Ali.