NETSTREIT Corp. Q1 FY2022 Earnings Call

We thank you for joining us for NETSTREIT's first quarter 2022 earnings conference call. In addition to the press release distributed yesterday after market closed, we posted a supplemental package and an updated investor presentation. Both can be found in the Investor Relations section of the company's website at www.netstreit.com. On today's call, management's remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements address matters that are subject to risks and uncertainties that may cause actual results to differ from those discussed today. For more information about these risk factors, we encourage you to review our Form 10-K for the year ended December 31st, 2021, and our other SEC filings. All forward-looking statements are made as of the date hereof and NETSTREIT assumes no obligation to update any forward-looking statements in the future. In addition, certain financial information presented on this call includes non-GAAP financial measures. Please refer to our earnings release and supplemental package for definitions, GAAP reconciliations, and an explanation of why we believe such non-GAAP financial measures are useful to investors. Today's conference call is hosted by NETSTREIT's Chief Executive Officer, Mark Manheimer, and Chief Financial Officer, Andy Blocher. They will make some prepared remarks and then we will open the call for your questions. Now I'll turn the call over to Mark.

Good morning everyone, and welcome to our first quarter 2022 earnings conference call. I'm pleased to share with everyone our strong start to the year, completing over $135 million in net investment activity during the quarter, including acquisitions, developments where rent has commenced, and our first ever secured mortgage loan with an option to purchase. We acquired 34 properties for $90 million at an initial cash capitalization rate of 6.3% and a weighted average lease term of 8.2 years. In addition, rent has commenced on two development projects that had total cost of $7.6 million and had a weighted average investment yield of 7.6%. We also provided $5 million of funding to support ongoing development projects and one new development for an investment-grade profile tenant. At quarter-end, we had nine projects under development, representing $37 million of additional investment. During the quarter, we entered into our first ever convertible mortgage loan agreement with a developer, a $40.4 million secured loan with an 18-month term and an interest rate of 6%. The loan is collateralized by three parcels of land that include a strong performing Home Depot located in the Portland, Oregon MSA. And funding the loan to value was approximately 75%. Upon the completion of the developer's plan to redevelop and reposition the assets and with certain conditions being met, NETSTREIT will have the right to purchase the Home Depot at an above-market cap rate equal to the current 6% interest rate. Additionally, we are comfortable with the real estate quality as security for our loan. We do not expect to purchase the other two assets that collateralize our loan. Stepping back, we view this transaction as a demonstration of how we can work with real estate owners to find creative transaction solutions while providing a path to fee simple ownership of high-quality real estate. In this case, we are providing the seller time to achieve their optimal resolution through a short-term loan while we receive an option to purchase the asset we want at an accretive return and achieve a superior interim yield on a well-secured loan. The investment-grade and investment-grade profile totals for our investment activities in the quarter, including acquisitions, developments where rent commenced, and the mortgage loan receivable were 56.5% and 21%. Lastly, we disposed of a casual dining restaurant during the quarter for a sales price of $2.4 million representing a 5.5% cash cap rate. We will continue to opportunistically reduce our exposure to select categories including casual dining, banking, and health and fitness. At the end of the first quarter, our portfolio was comprised of 361 properties with 71 tenants, contributing $77 million of annualized base rent. The portfolio had a weighted average lease term remaining of 9.6 years with 80.6% of ABR represented by tenants with investment-grade ratings or investment-grade profiles and the portfolio remains 100% occupied. New tenants added in the quarter include a Publix grocery store, a Panera Bread, and a Family Fare grocery store. In addition, we added one new state, Nevada to our portfolio during the quarter. As we look ahead, our pipeline continues to grow as we source opportunities through various channels and work creatively with tenants to unlock value and provide capital while maintaining our portfolio quality and returns. At this time, we believe we are well-positioned to achieve our increased investment target for the year. Before I hand the call off to Andy to go over the first quarter financial results, I want to take a moment to remind everyone of the unique characteristics of NETSTREIT. Since our formation in 2019, we have curated and built our portfolio strategically. Our investment-grade percentage remains one of the highest in the net lease space. Our portfolio is largely made up of tenants in defensive industries and we have no legacy issues with our assets. We have focused on tenants and industries that will perform very well in any economic environment with a large capital cushion to respond and adapt to various evolutions in the retail space. With rising inflation and interest rates as well as global uncertainty, we are confident that our portfolio is well-positioned to deliver the most stable cash flows in our space, even as we seek to meet our increased growth expectations for 2022. With that, I'll turn the call over to Andy to go over our first-quarter financial results and 2022 guidance.

Thank you, Mark and once again, thank you for joining us on today's call. In our earnings release published yesterday after market close, we reported net income of $0.04, core FFO of $0.28, and AFFO of $0.29 per diluted share for the first quarter. The portfolio's annualized base rent grew to $77 million in the first quarter, up 60% from the first quarter of last year, driven by acquisitions and developments since the prior year's quarter. Interest expense increased to $1.2 million from $0.9 million due to our higher average balance outstanding on the revolver compared to the first quarter of 2021. G&A increased to $4.2 million in the first quarter compared to $3.1 million from first quarter of 2021, primarily due to the increased number of employees as we grew our staff from 20 at the start of 2021 to 26 today, and the opening of our new corporate office. Turning to our balance sheet at quarter-end, we had total debt of $295 million outstanding, of which $175 million is from our fully hedged term loan with a remaining balance from our revolving line of credit. We have no debt maturities until the maturity of our revolver in December 2023, which is subject to a one-year extension option to align with the December 2024 maturity of our $175 million term loan. Moving on to our capital markets activity during the quarter, in early January, we entered into forward sale agreements related to over 10.3 million shares of our common stock at an offering price of $22.25 per share. On March 30th, we settled over 3.4 million shares receiving net proceeds of $72 million after deducting fees and expenses we have until January 10th, 2023 to settle the remaining shares. Also during the quarter, we issued shares in connection with our ATM program for net proceeds of approximately $3.5 million after deducting underwriting discounts and transaction costs of about $100,000. With our successful capital market activities during the first quarter, we have significant dry powder in hand to fund most of our targeted investment activity for 2022. At March 31st, 2022, our net debt to annualized adjusted EBITDA ratio was 4.6 times, which was at the low end of our targeted leverage range of 4.5 to 5.5 times. After giving consideration to the remaining shares in the forward sales agreement, our net debt to annualized adjusted EBITDA ratio would be 2.3 times. With regard to our dividend earlier this week, the Board declared a $0.20 regular quarterly cash dividend to be payable on June 15 to shareholders of record as of June 1st. Our payout ratio for the quarter was just under 69%. We are increasing our 2022 AFFO per share guidance range to $1.14 to $1.17 per share and net investment guidance to at least $500 million for the year. Our guidance includes the following assumptions: increased investment activity in the year including developments where rent commenced, mortgage loan receivables, and net of dispositions to at least $500 million, cash G&A to remain in the range of $14.5 million to $15 million, which is inclusive of transaction costs. Non-cash compensation expense is expected to be in the range of $5 million to $5.5 million. Cash interest expense is being increased to the range of $5.5 million to $6.5 million, reflecting the significant rise in short-term base rates. Non-cash deferred financing fee amortization, which is not included in our cash interest expense, remains unchanged at approximately $600,000. For the full-year 2022, we expect diluted weighted average shares outstanding, which includes the impact of OP units, to be in the range of 52 million to 54 million shares. Echoing Mark's earlier comment, we're off to a great start this year. We are highly confident that our investment strategy positions us to continually deliver a predictable cash flow in a time of global uncertainty through our ability to regularly source and finance accretive deals to grow our best-in-class portfolio.

Your first question comes from Nate Crossett with Berenberg. Please go ahead.

I was wondering maybe you could just comment on the deal flow so far in Q2, your visibility into the pipeline, and what you're seeing in terms of pricing.

Yes, sure. The pipeline is probably a little bit more robust than what we typically see at this point in the quarter. So, we're feeling pretty good about the second quarter and a few transactions that I think will likely leak into the third quarter. As it relates to what we're seeing on pricing, we certainly are seeing a number of buyers falling out of contract on some of their deals and pushing back as their financing costs have increased. So, I think there is a little bit more opportunity on some deals that have come back to us.

Okay, that's helpful. And then, maybe just one on the mortgage loan. Are there more of those in the pipeline and maybe you can just talk to that specific transaction. How did it come about, was it off-market? Are there other opportunities with this developer? Things like that.

Yes, sure. So, specific to that opportunity, we just viewed that as a really good opportunity to come in, provide capital to that developer that needed to do some work, re-parcel off the Home Depot that we'd like to own long-term, and then sell off a couple of outparcels at much lower cap rates than what we would like to acquire assets at. So, at a 75% LTV type situation, with some pretty clear goals that they needed to accomplish that we think are pretty achievable in the short term, it was a good way for us to get our hands on an asset sometime in the next 18 months at a very aggressive cap rate. It's a Home Depot that has some of the best foot traffic in the country, which is typically a location that we have a lot of trouble acquiring. Now, I think we'll likely do more business with this particular developer, likely won’t look quite like this. Not to say that we wouldn't do a similar type of transaction, but I think the circumstances here were pretty unique where we could come in with a very low-risk option to come in and take down a property at very attractive pricing.

Thank you. Next question comes from Todd Thomas with KeyBanc Capital Markets. Please go ahead.

Good morning. Just following up first on the investment environment. Mark, what's driving the increase in the investment pipeline that you cited and then, can you comment on whether you anticipate any change in pricing or cap rates as we move further throughout the back half of the year?

Yes, sure. I mean, it's always difficult to predict exactly where cap rates are going to go, but we do anticipate cap rates moving up a little bit on the margin. What's really driving our pipeline is we've seen a number of different types of buyers that have really had trouble getting their financing. As you're aware, our approach is to look for the investments that fit our criteria and then we try to get the pricing that works for us. The second part is more challenging. So, with a lot of buyers kind of falling out of contracts and not being able to perform, that has allowed us to get back involved with a lot of these transactions. It's always tough to predict how this plays out, but we've seen more portfolio opportunities, which historically, we've done very few. We've completed a couple of deals over $50 million, but that's typically not our focus. When you think about the buyers that were driving cap rate compression overall in the net lease retail space, those are higher LTV portfolio buyers that can no longer get financing to meet their cash-on-cash yields. We're also seeing some of those deals potentially come back to us. There are other public buyers that are still aggressive in the market. So, we're cautiously optimistic that we may be able to pursue some larger transactions, although we will continue to stick to our core strategy, which includes smaller portfolios and one-off transactions.

Okay. Regarding dispositions, you indicated that you would keep working on reducing exposure to casual dining, banking, and health and fitness. What are your target levels for those exposures and what is the timeline to achieve them? If you are encountering some smaller or medium-sized portfolio deals, is there a chance to rotate or recycle capital a bit sooner?

Yeah, absolutely. So, we're always opportunistic when considering dispositions. We added a portfolio this quarter, which included a bank, so we're looking to sell that pretty quickly. We think we can do that at an accretive price and in casual dining, we've reduced our exposure to under 1%. I think that's probably a healthy area to stick around for us. We did add one location at Chili's that does over $4 million in sales, so we're a little less concerned about that particular location with really low rents. Each situation is underwritten to its individual characteristics. I think casual dining will likely remain around 1% of our portfolio, but we will be very selective about what we're willing to maintain. In terms of banks, I think you'll likely see that eventually get down to zero.

Next question comes from Greg McGinniss with Scotiabank. Please go ahead.

Hi, this is Jason Wayne with Greg. Good morning. So, you mentioned last quarter about potentially raising debt in the back half of this year. I was just wondering if that's still the expectation and what kind of rates you would anticipate achieving on that?

Yes, Jason. Yes, it is from our perspective. We do continue to anticipate raising additional debt in the back half of the year. It's primarily to term out what will become a more permanent line balance on our revolver. We have been discussing a 10-year private placement in the 4% range, but that market is in pretty significant disarray with increased base rates and widening spreads. The indicative levels now are probably between 5% and 5.25%. We do have other attractive options that allow us to secure term loans of five to seven years through the bank market. I would anticipate that once we put this quarter's earnings behind us, Randy and I will go out to the market and start evaluating alternatives for a recast of the line of credit while maintaining as much optionality as we can to lock in term into the future. The increase in interest expense expectations reflected in our guidance aligns with the opportunity set we see as of today.

Next question comes from Josh Dennerlein with Bank of America.

Good morning. This is Lizzy Doykin speaking for Josh. I wanted to revisit the state of the transactions market. Are you noticing any activity from leveraged buyers, or is the current volatility in the debt market affecting your ability to pursue certain opportunities? Could you share your thoughts on that or any potential challenges as you evaluate transactions?

Yes, sure. We are seeing some of the higher-leveraged type buyers, by our LTV buyers, that are relying on, say, 75% type LTV transactions, more or less pulled out of the market, especially in some portfolio deals. To give you an idea of how we typically operate, when we see larger portfolio transactions that are marketed, we will typically bid on those and just never hear back from the broker because we aren't really competitive on pricing. In this new environment, we are getting callbacks, which is definitely a significant change. I wouldn’t anticipate we will do a lot of larger portfolios, but we are now likely positioned to bid in the top three or four instead of being seventh or eighth in most cases. This shift suggests there aren't as many private buyers using leverage when transacting.

Okay, great. And I just wanted to dig into your process of being more selective about certain industries that you look to expand into. Can you discuss whether your strategy remains the same with respect to screening tenants or opportunities? Is there anything in particular with Publix that was new to your approach in considering opportunities?

Yes, sure. As it relates to Publix, I think we've always wanted to add them to our portfolio. It's just difficult to make the pricing work in most situations. This particular transaction is one we have worked on for quite some time. It included a few outparcels, one being a Wells Fargo Bank, which we are taking on. We put that in the TRS and then we are going to sell it. This had a few moving pieces that allowed us to get in front of it and successfully close it. We’d love to do more of these types of transactions, but I don't think our investment criteria has really changed since we formed the company back in 2019. Our aim has always been to focus on tenancy that will perform well in any economic cycle. Given the current situation, there may be some pressure on the consumer, so we went through our entire portfolio and assessed what is discretionary and what isn't. Fortunately, most of it is necessity-based and belongs to really defensive categories. We believe we're well-positioned to collect all of our rent, which we consider a differentiator for our approach.

Great. Thank you. That's helpful. Just a follow-up. Would you say your focus has increased on the defensive category?

Yes, I mean, that's been our DNA from day one, but we're taking a hard look at the portfolio and assessing not just the underwriting from our acquisitions but also the current landscape. We're confident in the portfolio. There might be some outliers that we may look to sell, particularly in casual dining, an area we've mentioned earlier. If the consumer experiences pressure, we’ve seen that category suffer in the past. Therefore, we will be extremely selective with some of the categories we're in.

Next question comes from Nicholas Joseph with Citi. Please go ahead.

Thanks. For the development spend, what's the exposure to rising construction costs and how does that impact the targeted yield?

Yes, it's a great question. There are many different ways to approach development. We've chosen to take a very conservative path where we underwrite the developer, and all cost overruns are the developer's responsibility. We require leasing in hand and are not accountable for any cost overruns. Therefore, we haven't encountered any issues there. That said, I believe rising costs will negatively affect future developments in terms of profitability; retailers may need to pay more rent, or developers will have to accept lower profits, which are already slim. I expect that segment of our pipeline will experience some pressure and may not grow as quickly as it would without rising construction and labor costs.

Thanks. But the existing development pipeline is pretty locked in from your standpoint in terms of the yield.

Correct. That's right. Thank you.

Thank you. I will now turn the floor over to Mark for closing remarks.

Well, thanks everybody for joining us today and we look forward to keeping the dialogue going. Have a good day.

This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.