NETSTREIT Corp. Q3 FY2023 Earnings Call

Greetings and welcome to the NETSTREIT Third Quarter 2023 Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Amy An, Director of Investor Relations. Thank you. You may begin.

We thank you for joining us for NETSTREIT's third quarter 2023 earnings conference call. In addition to the press release distributed yesterday after market close, 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 31, 2022, 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 of our non-GAAP measures, reconciliations to the most comparable GAAP measure, 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, Dan Donlan. 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 thank you for being with us today for our third quarter conference call. Given the recent shifts in the capital and property markets, I want to start by discussing how NETSTREIT is positioned in what we anticipate will be a more challenging landscape for consumers, as well as for certain retailers. We will explore the opportunities we see and our operational plans in this environment. The challenges we foresee for many retailers are largely due to a consumer base that is not expected to maintain spending levels seen in previous years, particularly among lower-income consumers purchasing discretionary items. While a few of our tenants have a mix of products that includes some discretionary items that might face pressure, our portfolio focuses on necessity retailers, off-price value merchants, and viable service providers. We believe this defensive approach, along with our tenants' strong financial positions and access to capital, will enable our portfolio to generate reliable cash flow over the long term. Despite potential risks related to top-line performance and gross margins for some investment-grade tenants, we do not anticipate these pressures affecting their ability to meet financial obligations, including rent payments. We remain proactive in monitoring our portfolio, and where we identify risk, we have been strategically reallocating capital into less vulnerable assets that generally offer higher initial cash yields. Regarding credit, we currently have just one tenant, Big Lots, on our watchlist, which now accounts for 1.9% of our annual base rent, down from 2.4% last quarter. While we may look to further reduce this exposure in the coming quarters, it is important to note that the nine infill assets we own are situated in areas with strong demographics, below-market rents, and significant foot traffic. Specifically, our remaining locations boast an average five-mile population density exceeding 100,000 people, with average household incomes around $80,000, which is appealing to most retailers considering market expansion. Furthermore, our average rent per square foot of $6.90 is notably below market rates. Additionally, tracking store-level foot traffic using Placer.ai, our Big Lots locations rank in the top 75 percentile across the entire chain on average. Although we may continue to limit our exposure to Big Lots, we do not see any long-term economic risk associated with these assets, reflecting the strong fundamentals of the real estate we have underwritten since our inception. Another area of risk we observe in the retail sector involves tenants with significant floating-rate debt and upcoming low-cost debt maturities. Thanks to the financial transparency we receive from tenants quarterly, we can assess exposure accurately. Less than 9% of our tenants, as measured by annual base rent, have debt coming due between now and the end of 2025. Most of this concentration, 7.5%, is related to Walgreens, which has excellent access to capital. Considering our limited exposure to retailers relying on discretionary spending from lower-income consumers, minimal refinance risk among our tenants in the coming years, and only 2.3% of our annual base rent set to expire by year-end 2025, we remain optimistic about our portfolio's ability to produce consistent cash flow as we navigate a possibly volatile macro environment. As of September 30, our portfolio included 547 investments leased to 85 tenants across 26 retail and industrial sectors in 45 states. The annualized base rent for our portfolio was $124.3 million, with 83.3% leased to tenants holding investment-grade ratings or profiles. We maintained 100% occupancy, and the weighted average remaining lease term stood at 9.3 years. In terms of external growth, we finalized $117.5 million in investments this quarter with a blended cash yield of 7%. These investments have a weighted average remaining lease term of 10 years, with 97.2% leased to investment-grade or investment-grade profile tenants. Additionally, we sold six properties for gross proceeds of $13.5 million at a blended cash yield of 6.9%, showcasing our ability to effectively recycle capital while enhancing our portfolio's quality and risk profile. In total, we achieved $103.9 million in net investment activity in the third quarter, bringing our year-to-date total to $327.9 million. While we anticipate more acquisition opportunities at higher cap rates in the fourth quarter than seen in 2023, we also find numerous chances to sell assets at persistently low cap rates to trade buyers, thus aiming to increase our selling efforts to benefit from this disparity. Before handing the call over to Dan, I want to share some insights on our strategy and expectations as we conclude 2023 and enter 2024. Since our inception and IPO a few years back, we have diligently built one of the highest credit quality net lease portfolios in the freestanding retail sector by partnering with leading retailers in the country. We have a history of no rent interruptions, even during a global pandemic, and have maintained zero vacancies. As the current narrative is filled with concerns about potential recessions, prolonged high-interest rates, and rising consumer credit delinquencies, we believe our disciplined underwriting approach since our inception positions our portfolio to excel amid increased macro uncertainty. With that, I will turn it over to Dan to discuss our third-quarter financial results, balance sheet, and 2023 guidance updates.

Thank you, Mark, and thank you everyone for joining our call today. Yesterday, following the market close, we released our third quarter earnings, reporting a net income of $4.2 million or $0.06 per diluted share. Our Core FFO was $21.2 million for the quarter, equivalent to $0.31 per diluted share. The AFFO also reached $21.4 million, $0.31 per diluted share, reflecting a 3% increase compared to the same period last year. Total G&A expense, excluding one-time items, stood at $5.1 million, accounting for 14.9% of total revenues. This is an improvement compared to the previous quarter and the same quarter last year, where G&A as a percentage of revenues was 16% and 18.2%, respectively. Looking ahead to next year, we anticipate our G&A will continue to align with our asset base and total revenues, as we've achieved the scale necessary to operate effectively moving forward. Regarding our balance sheet, total net debt was $567.5 million at the end of the quarter, with a weighted average interest rate of 3.57%. Notably, including the impact of extension options at our discretion, we have no debt maturing until January 2027. In our capital markets activities, we raised $126 million in equity through our ATM during the quarter, mostly completed on a forward basis. As of the end of the quarter, we had $98.7 million of unsettled ATM equity. As announced on July 3, we closed a new $200 million senior unsecured term loan with a delayed draw option, which matures fully in January 2029. This loan has an accordion feature allowing us to increase the total loan amount to $400 million. At closing, we drew $150 million and plan to draw the remaining $100 million in the first quarter of 2024. We also fixed our $250 million term loan at a fixed all-in rate of 4.99% through January 2029. By quarter end, our liquidity was $564.6 million, consisting of $7.9 million in cash on hand, $358 million available on our revolving credit facility, $98.7 million in available forward equity, and $100 million available on our 2029 term loan. In terms of leverage, adjusting for foreign equity, our net debt to annualized adjusted EBITDAre was 4.2 times at quarter end, remaining below the lower end of our targeted leverage range of 4.5 to 5.5 times. Moving on to guidance, we are revising our AFFO per share guidance range to $1.21 to $1.23, up from $1.20 to $1.23, which represents a 5% year-over-year growth at the midpoint. Regarding our external growth fund, we now anticipate closing approximately $450 million in net investment activity. Lastly, concerning our dividend, on October 24, the Board declared a quarterly cash dividend of $0.205 per share, which will be payable on December 15 to shareholders of record as of December 1. Based on this dividend, our AFFO payout ratio for the third quarter was 66%. With that, operator, we will now open the line for questions.

Our first question comes from Todd Thomas with KeyBanc Capital Markets.

Hi, thanks. Good morning. Mark, for my first question, you mentioned that you are observing appealing capital still available as you consider recycling capital. What is the current spread between the cap rates for dispositions and acquisitions that you are experiencing?

Yes, sure. So I mean, we're focused on really trying to find a trade buyer in 1031 exchanges. So in kind of one-off type situations, we're selling assets anywhere from, call it a five cap to seven cap depending on lease term and where we think we can redeploy that capital. I'm always hesitant to give a real concrete number on where we're going to go with dispositions just because we're relying on other parties to complete the transaction, and that's out of our control. So the mix could really swing that one way or the other, but for like kind – types of assets, we think we're picking up anywhere from typically 50 basis points to 100 basis points.

Okay. And then it sounds like you're starting to see investment yields improve a little bit on new deals that you're looking at. Can you just describe a little bit more about what you're seeing there in terms of price trends? You know, I guess sort of vis-a-vis you know that the sort of 2023, you know, cash yields that you've achieved and sort of the 7% in the third quarter?

Yes, sure. No, absolutely. We are seeing cap rates move up, and so we, at one point, were acquiring assets at kind of the low-sixes, and that kind of trended up to mid-sixes year-end of the year last year, and early this year up into the high sixes, and now a seven cap in the most recent quarter. We would expect the fourth quarter to be even higher than that. We're certainly not looking to transact really anything in the sixes. So I would expect to see 20-plus basis points in the fourth quarter. Some of that's really just going to be dragged down by some developments that we had signed up in the past that were already funding. I think on new transactions that are likely to close more in the first quarter are likely to pick up even another 20 basis points, 30 basis points beyond that.

Okay. And then just last question, I guess. I realize conditions are sort of fluid here, but I was just wondering if you can maybe provide a little bit of insight around how you're thinking about investments and maybe dispositions as well? So net investments, you know, really heading into 2024 just given the current environment today?

Yes, sure. I mean, I think with where we're seeing the acquisition market, while it's getting better, it's really I don't think we're getting enough spread to go out and raise equity and deploy capital where we see it today. We do see opportunities like we mentioned on the disposition, and then redeploying through capital recycling, and see some pretty attractive opportunities there. But we'd really need to see a material improvement in our stock price, or see cap rates really move into the eights, for us to consider turning on the spigot of acquiring assets and raising equity.

Our next question comes from Joshua Dennerlein with Bank of America.

Hi. This is on behalf of Josh. I have a quick question regarding the pharmacy sector. With your current acquisition, are you noticing any changes in competition for the higher credit quality assets that you are pursuing?

I think we have seen this trend for most of the year, and it's even more evident today with the private buyer largely absent. The opportunities available have never been better in my career. However, the cost of capital presents a challenge that we need to manage. Developers and tenants aiming to expand, including sale-leaseback transactions, are encountering significant opportunities. The market has shifted from a seller's market to a buyer's market, with very few bids in the private sector apart from the occasional 1031 buyer, which we are leveraging to navigate the disposition market. Overall, it appears that our transaction volume is down by about 70% to 80%, while competition has declined by approximately 90% to 95%.

Our next question comes from Eric Wolfe with Citi.

It's actually Nick Joseph here with Eric. Just back to sourcing of investments, just kind of curious your thoughts and kind of the rationale of issuing equity in the mid-$16s given the NAV, at least street NAV, in the nineteens, where you've talked about investment spreads and transaction cap rates historically. So just trying to understand the thought process there and kind of a value creation calculation.

Yes. Hey Nick, it's Dan Donlan. When considering the price and including the minimal net price, along with the recent term loan and its effect on free cash flow, we need to maintain approximately a 100 basis point spread in relation to our pipeline as we approach the fourth quarter. Our focus remains on earnings growth, while we also take into account the implied cap rate. It slightly impacted the implied cap rate, decreasing it by around 10 basis points. Overall, this perspective confirms that it was beneficial to our AFFO per share.

Yes. I guess one of the advantages that you have is that you're smaller and so you can kind of grow off of that base. And so how do you think about the 100 basis points investment spread off of that and kind of taking away some of that advantage versus putting pencils down and waiting for better opportunity?

Yes, sure. I mean we'd like to get back to more normalized spreads, which I think we've said before, is kind of in the 150 basis points to a 175 basis points spread. But yes, we feel like 100 basis points is adequate and provide some growth in there. Scaling into the G&A is also something that is we view it as helpful.

Yes. Hey, Nick. It would imply low single-digit year-over-year AFFO growth. This is based on internal rent growth of about 1%. Credit loss is around 30 basis points. After dividends, we have about $32 million of free cash flow to reinvest. The impact on 2023's investments and leverage is around the midpoint of our range. If we had extended our $175 million 2024 term loan to 2027, we probably would be aiming for more mid-single-digit AFFO growth year over year. However, we deemed it wise to extend that term loan and switch to a fixed rate given the circumstances in May and June. We are pleased with that decision.

Our next question comes from Greg McGinniss with Scotiabank.

Well, everyone, thanks for taking the question. So obviously, it takes time for sellers to recognize reality, and for cap rates to increase. So how are you weighing deploying capital today at these seven, low seven cap rates, versus holding back, potentially collecting some cash interest income, and investing in a few quarters once cap rates move higher? Based on our math, long run IRR tends to really appreciate another 25 to 50 basis points of investment yield.

Yes, that's a good question. For the fourth quarter, we are mostly finished with acquisitions. The guidance has a slight adjustment related to properties we are considering selling, depending on whether potential buyers follow through. If they do not, that number could be slightly above $450 million; if they do, it might be slightly lower, but that is somewhat beyond our control. We still have time to utilize the capital from our recent equity raise, and we believe cap rates will likely be higher in early 2024 compared to today's rates. It's hard to predict exactly how much higher they will go, but we want to keep some resources available for early next year.

Yes. I mean, it should continue to grow. That's really the interest we receive from developers as we're funding their development. You should see it start to tick up some over time. I don't think it's ever going to eclipse the capitalized interest.

Is that part of maybe some of the headwinds on a deal that you agreed to perhaps before the cost of capital increased this much?

Yes, look, I mean, some of the developments that we entered into were in the first and second quarter, and the yields on those on were low sevens, high sixes. I would note that they had much longer lease terms than what has historically been achieved with those retailers, as well as annual bumps, which you know has not also been historically recognized as well.

And so sorry, last follow-up here.

Go ahead.

Yes, I can appreciate how you guys were able to change some of those lease terms that we hadn't seen in the past, which definitely is a positive for those. In thinking about here going forward, have those same retailers been open to further increasing potential yields on those investments?

I mean, I think some of the retailers are really pressed to grow their store count. They really need institutional capital to come in. They can't rely on the 1031 market like they had in the past through their developer network. So hard to say exactly where all those negotiations go as they're ongoing, but I think if you need institutional capital, most institutions like us like to have annual increases in the leases. So I would expect that to continue on the margin.

Our next question comes from Haendel St. Juste with Mizuho.

Hi Good morning. This is Ravi Vaidya on the phone for Haendel. Hope you guys are doing well. During the quarter, you issued equity when the stock was at $16.50. Can we consider this a watermark as to when you'd consider issuing equity again?

Yes, hey, Ravi. Look, where you raise equity is highly dependent upon the opportunities that you see. Right now, the opportunities that we see relative to our cost of equity as it is, there's not adequate spread there. So we're not going to ever put a number on where we would raise capital or not raise capital. It's ultimately going to depend upon the opportunity set where that's priced, and where are we trade relative to that opportunity set.

Got it. And you ended the quarter with leverage at 4.2, and inclusive of the forward. What are you willing to let leverage tick up to in order to execute on your capital deployment goals?

So our stated leverage range is 4.5 times to 5.5 times, and I think you should expect us to operate within that range in 2024 and beyond. Obviously that we're mindful of the range, and I think you're probably likely to see us shake closer to the midpoint of that range over time.

Our next question comes from Alec Feygin with Baird.

Yes, thank you, guys for taking my question. Quick question, just on dispositions, solid slight uptick in that. Do you guys plan on continuing to dispose of some properties in the portfolio and what's the opportunities up there?

Yes, we do. I would expect the dispositions to ramp up a little bit here in the fourth quarter, and potentially beyond the fourth quarter. We do see a pretty attractive opportunity to not only accretively recycle capital, but also extend out lease terms by replacing those assets with longer lease term assets with better rental increases and potentially better properties, and we believe we can do that accretively.

Our next question comes from Linda Tsai with Jefferies.

Hi. Last quarter, you didn't have any shares outstanding under your forward equity program, but then this quarter you have about 6 million shares?

Yes, yes, that's correct.

Oh. Just wondering what happened during the quarter.

Yes, we sold those shares during the quarter through a forward block.

Okay, got it. Are there any updates on Big Lots? I know they are on your watchlist, but what's your overall view on what’s happening with them?

Yes, sure. I mean, obviously, they've had a less-than-great run over the past several quarters, but they are making some efforts to try to improve their free cash flow, which was neutral last quarter. But that was really driven by cuts to their working capital and you really can't do that for several quarters in a row. So we're really kind of trying to look to see them improve their operations and get the positive EBITDA after CapEx to start to feel better about their tenant health, but we are expecting to see some improvement in their gross margin here in a month when they announce earnings. So we'll be looking forward to that.

Our next question comes from Ki Bin Kim with Truist Securities.

Thanks. Good morning. If you had to go raise new debt in the bank markets today, what are you getting quoted?

Yes, Ki Bin, we're being quoted in the mid-fives, but to be honest, we currently have about $100 million of unsettled equity. We also have $100 million that we have not yet drawn down on the existing term loan. There isn't really any need at this moment to take on any additional long-term debt issuance if you consider term-loan debt as long-term debt.

Okay. And in terms of drug stores, if you look at the closure plans that have come out recently, any kind of broader common themes that you're seeing? Or is it just four-wall coverage? And when you overlay that with your tenant exposures, any kind of impact that you might see longer-term?

Yes. I mean, we don't think we're going to have any impact with the locations that we have. We've got a very good, really good relationship, both with CVS and Walgreens. We do not have any rated exposure. And so we talk to them before we're acquiring assets, and really get updates as we see news like this, and call them up. And fortunately, they've been very open with us, and telling us that the stores that we have are not on any closure list. But yes, as it relates to the ones that they are closing, some of those are leases that are rolling over where they already have a presence in some of those markets. You know, they've grown through some mergers over the years, and really have multiple stores in the same markets. And they feel like they don't really need that number of stores in those markets. And then there are obviously some locations that just don't generate positive cash flow, so those are the ones that they look to close.

Okay. Thank you.

We have reached the end of our question-and-answer session. I would now like to turn the floor back over to Mark Manheimer for closing comments.

Thanks, everybody, for joining us today. We look forward to seeing you in the next few weeks at the conferences and appreciate everybody's time. Thanks.

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