NETSTREIT Corp. Q1 FY2024 Earnings Call

Ladies and gentlemen, good morning, and welcome to the NETSTREIT Corp. First Quarter 2024 Earnings Conference Call. As a reminder, this conference is being recorded.

We thank you for joining us for NETSTREIT's First Quarter 2024 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, 2023, 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. Mark?

Thank you, Amy, and thank you all for taking the time to join us this morning on our First Quarter 2024 Earnings Call. First, I want to extend my thanks to the NETSTREIT team. Our strong start to the year would not have been possible without their fantastic work. We kicked off the year as one of only two REITs to raise follow-on equity in January, while also remaining active on our ATM program. We have raised nearly $230 million of equity year-to-date, which gives the team ample dry powder to transact at our current investment pace through year-end. Due to a drastic decrease in competition, we are continuing to pursue investment opportunities at attractive prices. The team remains diligently focused on investing in properties with the strongest tenants in defensive retail sectors that heavily rely on their physical locations to make profit. We continue to see great opportunities with not only investment-grade tenants, which now make up a sector-leading 71.1% of our portfolio, but also with investment-grade profile tenants and low-risk sub-investment-grade and unrated tenants. And while the buyer pool has shrunk, we also continue to execute on strategic dispositions to lower our concentration in certain tenants and/or recycle the capital into investments with longer leases and better rent escalations. In the first quarter, we completed over $129 million of gross investment activity at a blended cash yield of 7.5%, a 30 basis point sequential quarter-over-quarter increase. Acquisitions closed in the quarter were with strong nationally recognized tenants such as Tractor Supply, Dollar General, and Brickstone, Firestone to name a few. From a tenant perspective, 84.8% of our investments completed in the quarter were with investment-grade tenants, which includes the completion of 10 new developments. Moving to our disposition activity, we sold 12 properties for $21.6 million at a 6.8% cash yield in the quarter. These properties were leased to tenants in the dollar store, drugstore pharmacy, discount retail, and convenience store industries. At quarter end, our portfolio consisted of 628 investments with an ABR of $140.3 million. Our 88 tenants operate in 26 industries across 45 states with 84.4% of our portfolio leased to investment-grade or investment-grade profile tenants. Our focus on long-term leases and high-quality tenants has provided us with a favorable lease expiration schedule. For example, subsequent to quarter end, we renewed the one lease that was expiring in 2024 for a 12.5% increase in rent. Looking out to 2025, we have 1.8% of ABR expiring, which our team is actively addressing. We currently expect these expirations to have a positive impact on our cash flow and our portfolio weighted average lease term. We believe our high credit quality and minimal lease expiration risk in the near term provides stability of our cash flows. Turning to recent tenant headlines, I wanted to provide some commentary as it relates to Dollar Tree and their concentration within our portfolio. In March of this year, Dollar Tree, who acquired Family Dollar in 2015, announced that they intend to close several stores across the country, the bulk of which will be Family Dollar branded stores. This was not a surprise to us as we have been addressing our Family Dollar locations via asset sales and proactive lease extensions over the past few years. With that in mind, we currently own 19 Family Dollar branded stores, which comprise 1.4% of our ABR. Two of those stores or 13 basis points of our ABR have a lease that expires within 5 years. We would also note that in the last 12 months, we extended the initial lease terms of 10 stores with the 7 remaining stores having leases that were already long-term in nature. As such, we are confident in the productivity of our stores, and we were pleased to see none of our locations among the 103 Family Dollar stores on the initial closure list. Our relationship with Dollar Tree is strong, and we plan to continue working with them to minimize risk and maximize cash flows for our investors. Before I turn the call over to Dan, I wanted to reiterate a couple of points as it pertains to our balance sheet portfolio and tenancy. While there are multiple reported crosscurrents as it pertains to the health of the economy and the U.S. consumer, we believe our portfolio and tenant focus are well-positioned to weather a prolonged negative impact in consumer spending as well as provide a robust opportunity set from which to grow should the economic growth remain stable. Similarly, our low leverage and well-capitalized balance sheet provide us with sufficient capacity to grow externally should the capital markets remain volatile while also allowing us to remain highly competitive and opportunistic on the investment front should the environment for spread investing improve from current levels. With that, I'm going to turn the call over to Dan to discuss our key financial highlights for the quarter.

Thanks, Mark. Looking at our first quarter earnings results, we reported net income of $1 million or $0.01 per diluted share. Core FFO for the first quarter was $22.5 million or $0.30 per diluted share, and AFFO was $22.9 million or $0.31 per diluted share, which was a 3.3% increase over last year. Turning to the expense front, we saw total G&A excluding one-time severance payments decline 1% year-over-year to $4.85 million, while our cash G&A excluding one-time severance payments declined 11% year-over-year to $13.4 million. In addition, with our total quarterly G&A excluding one-time severance payments, representing 13% of total revenues in the quarter versus 17% of total revenues in the prior year quarter, our G&A continues to steadily rationalize relative to our revenue base. Turning to the balance sheet, our total adjusted net debt, which includes the impact of all forward equity as of quarter end, was $395.1 million. Our weighted average debt maturity is 3.9 years and our weighted average interest rate is 4.36%. Including extension options, which can be exercised at our discretion, we have no debt maturing until January 2027. During the quarter, please note that we drew the remaining $100 million on our 2029 term loan. As Mark mentioned, we were active on the capital markets front this quarter. Utilizing the constructive macro backdrop that existed in early January, we sold over $198 million Forward Equity at $18 per share in a follow-on offering. Additionally, we remain opportunistic with our ATM program with year-to-date forward sales of $31 million through the end of April, including $2 million sold in March. At quarter end, our liquidity was $638.1 million, which consisted of $22.3 million of cash on hand, $324.9 million available on our revolving credit facility, and $290.9 million of unsettled Forward Equity. Including the $28.7 million of unsettled equity from our April ATM activity, our pro forma liquidity at quarter end was $666.8 million. Turning to leverage, our adjusted net debt to annualized adjusted EBITDAre was 3.1x at quarter end, which remains well below our targeted leverage range of 4.5 to 5.5x. Furthermore, adjusting for our April ATM activity, our pro forma leverage declines to $2.9 million. Given this Forward Equity cushion, we can modestly exceed our 2023 net investment activity level and still end the year below the low end of our targeted leverage range with no additional equity required this year. Moving on to guidance, we're increasing the low end of our 2024 AFFO per share guidance to a new range of $1.25 to $1.28. In addition, we continue to expect cash G&A to range between $13.5 million and $14.5 million, which is exclusive of transaction costs and one-time severance payments. Lastly, on April 23, the Board declared a quarterly cash dividend of $0.205 per share. The dividend will be payable on June 14 to shareholders of record as of June 3. Based on the dividend amount, our AFFO payout ratio for the first quarter was 66%. With that, operator, we will now open the line for questions.

Our first question is from the line of Haendel St. Juste with Mizuho Securities.

My first question is about how we should interpret the first quarter activity and what it means for your capital deployment in the near term. You have mentioned that you can continue to buy at a sustainable pace without exceeding your leverage metrics. However, I'm curious about how we should view the cap rates and spreads. Are they reflective of the cost of capital that allows you to purchase high-grade assets in the current market?

Yes, I believe that given our current cost of capital and the opportunities we are seeing, you can expect us to continue deploying capital at a similar pace. Based on what we have acquired this year, it resembles what we have purchased in recent quarters. The spreads for investment-grade and non-investment-grade bonds have become significantly more attractive than before. Historically, we have concentrated on solid non-investment-grade tenants in industries that are not facing major challenges, in real estate that we consider adaptable, and in rents that we believe are replaceable, whether they are non-investment-grade or lean more towards an investment-grade profile. We may notice more opportunities in sale-leasebacks for the rest of the year. In the second quarter, we already see some appealing options in this area, pending pricing considerations. You could see up to half of our activity in the second quarter fitting into this category, and we are observing many more attractive opportunities on both the investment-grade and healthy non-investment-grade sides.

Yes. As we consider future equity or debt fundraising, we have already accomplished what we aimed for this year and through the first quarter. We can afford to be patient and wait for the market to provide opportunities, whether that involves capital or more attractive options with higher yields. This is why we are in our current capital position: we want to be ready to take advantage when opportunities arise. We have ample time to navigate the capital markets environment over the next three to four quarters.

Got it. Appreciate that. Maybe as a follow-up, just a bit more on how you're thinking about your ability to achieve your target 75 or 100 basis points of spread here. Should we, I guess, expect you to continue using maybe more term loan versus kind of given where the spot cost is 10-year unsecured debt here?

Currently, we have over $2 billion in gross assets. The 10-year market is not as efficient as the bank term loan market. However, with the $320 million in Forward Equity we have, our near-term capital needs will be easily met through this equity and our credit facility. We are not planning any long-term initiatives until early to mid-2025, and we will assess the market for term loans and private placements as that time approaches. Fortunately, we have sufficient capital at the moment, so there is no immediate concern.

Got it. Got it. My second question is on Big Lots. I just wanted to check in. They're not in your top 10 tenant list anymore. Curious if you're selling what the market is and just generally where you'd like that exposure to get to?

Yes, sure. Thanks, Haendel. Yes, look, I mean, we continue to monitor what's going on with Big Lots. They closed 48 stores last year, none of which are ours; they also opened another 15. It looks like they've finally rightsized inventories beginning to see improvement in margins, and their cost-cutting appears to be helping. But at the end of the day, we really need to kind of see the sales bottom out and hopefully start to increase versus having full confidence in their turnaround. So we're really relying on the strong real estate that we've got left after selling off a handful of those locations. Now we've got locations with below-market rents and attractive infill retail corridors. And so that's really our ultimate backstop. But we're open to potentially selling some more. We just don't feel like we have to be price takers with how attractive the real estate is that we're left with. There continues to be a market for those assets. I think we'd really like to see the cap rates to be a little bit more aggressive for us to pull the trigger, but we've got a couple of feelers out in the market. So I would not be shocked to see us move a couple more.

Great. Appreciate the color, guys.

Our next question is from Smedes Rose with Citibank.

I think since your last call with investors, this narrative has kind of just higher for longer, has taken hold. And I was just wondering if you could talk about what you're seeing in terms of seller pricing? Do you think there's more people just retreating at this point, given what I assume is an upward bias in cap rates? Or maybe just talk a little bit about the landscape of what you're seeing?

Yes, sure. No, it's certainly an interesting market, it does feel like the expectations have been muted on a lot of cuts coming. We started the year with the expectation, at least from the market, that we'd see call it 6 or 7 cuts during the year, which is largely why we raised some equity because we didn't see the macro quite the same way. But the seller market at that point in time was still really kind of banking on those rate cuts coming. Now obviously, I think the consensus is that we might get one in December or nothing at all. And so I think there's been a little bit more of an acceptance that we could be in a higher-for-longer market. We've seen a lot more actually opportunities than I would have expected. And that really keeps a lot of our competition on the sidelines, so it allows us to be very selective, and allows us to really negotiate terms the way we like to see them where we're not really competing against other people that are trying to buy the assets that we think that we are. So, I mean cap rates have continued to move up. What we're seeing in the second quarter, I think, will likely look a lot like the first quarter.

Sorry, did you say you expect second quarter cap rates to be similar to what you observed in the first quarter? Or do you think the sequential increase will be comparable?

I believe the rates in the second quarter will be comparable to the first quarter. We are still identifying additional opportunities for the second quarter based on what is closing, but our current pipeline appears similar. However, we are securing longer lease terms with improved rental increases.

Our next question is from Greg McGinniss with Scotiabank.

On the acquisition side, I'm just curious, should we kind of expect to see more of the same in terms of what you're looking to target from a concept and industry standpoint? Or are there any kind of new concept industries out there that, given your cost of capital, maybe you're now able to address or where cap rates have changed you're now able to address? Or I guess just any changes in terms of industries that you're targeting?

Yes, sure. And I mean you've seen specific mostly to Dollar General. You've seen that concentration move up quite a bit. A lot of that was funding developers that we committed to last year. So I think we've got maybe another call it, 4 or 5 months left of kind of funding some of that, but that's going to be a little bit less than what you've seen in the past. You will see a few new tenants come into the portfolio. We do think it's important for us to increase the diversification not only in the top 20 but also broadly across the portfolio. And we are seeing some attractive sale-leasebacks and other opportunities that we had in the past. There are a few that we've been active with on the development side that may not have popped into our top 20 but are kind of getting close there in the collision space. So I think you will see a few new tenants pop into the portfolio that I think we find to be very attractive, and cap rates would have been much lower, call it, 18, 24 months ago that we would not have been able to put in the portfolio.

Okay. And then on that development side, I believe you previously mentioned that you've been able to negotiate escalators into some of those development deals that previously didn't have them. Have there been any other changes on the leasing side in terms of being able to build escalators or different terms as the financing market has changed?

Yes. I mean, I think not much of a change quarter-over-quarter. But yes, I mean, we're getting better rent escalators in leases that historically have been flat. So that's driven a lot of our capital recycling program, bringing in some of those tenants with now longer leases with better rent bumps and then turning around and selling some of the flat leases with less term out of the portfolio and being able to do that slightly accretively has been something that we focused on, but no real big change quarter-over-quarter.

Okay. And final for me. Apologies if you already addressed this. But have you guys talked about bad debt expectations built into guidance for the year?

Yes, we did mention that during the last call. As we assess the situation today, we are still projecting an annualized performance of roughly 20 to 25 basis points at the upper end of our AFFO guidance range.

Our next question is from the line of Alec Feygin with Baird.

First one for me is, can you just talk about what are the categories that are in the assets held for sale?

Yes, it's a pretty big mix. We've got some of the Big Lots around there and a lot of the Dollar Stores that I mentioned where we're kind of recycling through to improve the escalators, but it's a pretty broad mix of property type.

Got it. And second one is, may provide some color on the current in-place rents for the 19 Family Dollar stores in the portfolio and where you think the market is at for those properties, if you did need to release them?

Yes. We're discussing an annual rent of $90,000 to $100,000 per property, which is quite affordable and we believe these rents are largely replaceable. We have worked closely with the tenant to understand their profitability and commitment to our sites. While it's possible they may close a few stores as they plan, we are encouraged to see that none of our properties were on their first list of 103 locations for closure. Nevertheless, we believe many of our properties are located in desirable areas, and we would attract interest from various tenants willing to pay similar or potentially higher rents.

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

This is Farrell Granath on behalf of Josh. I wanted to know if you could touch on what you're seeing in investment spreads relative to where you can deploy capital today?

Yes, sure. I mean, I'll take the first piece, which is most recent quarter 7.5. I think you're going to kind of expect to be kind of similar in the second quarter. We really only have visibility going out into the second quarter and not as far as getting into the third. So tough to project beyond that, but certainly gives us a pretty healthy spread off of where we raised capital earlier this year.

Great. And I know you already touched on Big Lots and Family Dollar. I was curious if there's any other color on tenant watch list.

Yes, we don't have anything on the watch list at the moment. To provide more detail, we are analyzing the product mix of our tenants, considering how discretionary their offerings are and who their customers are. We've noted that lower-income consumers are really facing challenges. While overall consumer health appears strong, highlighted by government statistics, it's becoming a divided situation where middle and upper-income groups are doing well, whereas lower-income consumers are struggling. This has been evident as some tenants are finding it difficult to pass on rising costs to consumers. A notable example is Walgreens, whose gross margins have declined from around 22-23% to over 18%, which is negatively affecting their cash flow. We're proactively addressing these potential risks. Fortunately, the financial health of our tenants doesn't raise major concerns, but many may face higher costs when refinancing their debt compared to a few years ago. Additionally, access to debt could become more difficult for some. Those are our main concerns, but nothing significant has emerged that warrants putting anyone on our watch list at this time.

Okay. And I was also curious, is there anything in the market that you're waiting to see? Or what's maybe leading to some hesitancy on providing a net investment guidance?

Yes, there has been considerable volatility in the markets over the past couple of years. We wanted to see cap rates increase, and we are making progress on that front. Earlier in the year, we didn't think it was advisable to release a number only to potentially revise it multiple times throughout the year. Generally speaking, regarding acquisitions, although we haven't provided specific guidance, you can expect us to allocate capital at a rate similar to last year if market conditions remain consistent.

Our next question is from the line of Todd Thomas with KeyBanc Capital Markets.

This is Antara Nag-Chaudhuri on for Todd Thomas. Apologies if you discussed this already, but could you discuss your current investment pipeline and where it stands just thinking about 2Q and 3Q volumes?

Yes, sure. I mean I think the volumes will probably continue to be spread fairly evenly over the year if market conditions continue to be similar. And so I don't think you'll see much of a change in yield or how much we deploy in the second quarter, third quarter, probably a little bit too far out for us to figure out, but you may see a couple of chunky deals that are in the sale-leaseback category and some that we're developing a little bit more or funding development for a little bit more than we have in the past.

Okay. Got it. And on disposition pricing, are you still able to achieve a sub-7 cap rate? Or are disposition cap rates trending higher?

They're trending higher a little bit on the margin. And I think depending on what we sell, it's going to drive that a little bit. But cap rates have moved up a little bit. I think really the issue has been on the disposition side and us getting kind of figuring out how we want to approach dispositions is there just aren't as many buyers. And so that helps us on the acquisition side where we're not really competing with anybody for acquiring the properties that we want to acquire. But then on the disposition side, it takes a little bit longer, and the buyers have been a little bit flakier than they've been in the past. So that's something that we're just making sure that we're staying on top of costs and not incurring a bunch of debt deal costs. But cap rates have moved up a little bit on dispositions. But I think what we're looking at potentially selling in this quarter very likely could be below 7%.

As there are no further questions, I now hand the conference over to Mark Manheimer for his closing comments. Mark?

Well, thank you, everyone, for joining. I really appreciate the support, and have a great day.

Thank you. The conference of NETSTREIT Corp has now concluded. Thank you for your participation. You may now disconnect your lines.