NETSTREIT Corp. Q3 FY2024 Earnings Call

We thank you for joining us for NETSTREIT's third 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.

Thank you, Amy, and thank you all for joining us this morning on our third quarter 2024 earnings call. I first want to congratulate the team on an outstanding quarter as we completed $152 million of gross investments, our highest quarter on record at a blended cash yield of 7.5% or 8% on a straight-line basis, which has been our average on a year-to-date basis. Similar to last quarter, a greater portion of our third quarter investments were sale-leasebacks as we have seen more attractive risk-adjusted returns emerge from our opportunity set within that marketplace. Additionally, by sourcing more volume from this channel, our quarterly acquisitions had a longer weighted-average lease term at 12.5 years with more attractive rent growth profiles. While our percentage investments leased to investment-grade and investment-grade profile tenants was below our portfolio average this quarter, we have continued to adhere to our stringent underwriting standards, which require healthy tenant credit profiles, strong unit-level cash flow, generic single-tenant boxes, above-average foot traffic, and replaceable rents among many other attributes. Included in this activity were four development projects totaling over $18 million that commenced rent in the quarter. As of today, our development pipeline consists of eight projects with a total estimated cost of $22 million, which includes estimated remaining funding of $7 million. Turning to the portfolio. We ended the quarter with investments in 671 properties that were 100% leased to 93 tenants operating in 26 industries across 45 states. From a credit perspective, over 75% of our total ABR is leased to investment-grade or investment-grade profile tenants. Our weighted-average lease term remaining on the portfolio is 9.5 years with less than 3% of ABR expiring through 2026. In addition to a robust quarter of investments, we also saw continued progress on the asset management front, which is indicative of the strength of our industry relationships and the speed at which our team can move when asked to perform. This was evidenced by our third quarter disposition activity as we executed on various strategic asset sales that reduced select tenant concentrations while accretively recycling the proceeds into investments with longer leases and better rent escalations, all told, we completed eight dispositions in the quarter for total proceeds of $24 million at a weighted cash yield of 7.3%. Turning to our industry concentrations. While the pharmacy and dollar store industries have garnered a number of less-than-positive headlines over the past few months, we remain eminently comfortable in the long-term productivity of our assets within these industries. Due to the in-depth analysis that we complete at underwriting, coupled with consistent dialogue we have with these operators, we do not currently foresee any discernible economic impact to our earnings stream from these industries, which represent just 50 basis points of total expiring ABR between now and 2028 year-end. As it pertains to Walgreens, we continue to believe that their planned store closures, which are likely to focus on near-term lease expirations and unprofitable locations should have minimal to no impact on our occupancy. Amongst many other factors, our conviction in this view is driven by the fact that more than two-thirds of our stores were purchased pursuant to Blend & Extend transactions, which is not only indicative of Walgreens' long-term commitment to our sites but also supports our view that our rents are more replaceable versus market. However, we felt it prudent to demonstrate that we can quickly and meaningfully reduce tenant concentrations even those that are perceived to have challenges while simultaneously reinvesting the proceeds at an accretive level. As outlined in the supplemental, we have reduced our Walgreens' concentration from 5.9% at second quarter end to its current concentration of 4.8%. While we endeavor to have all tenant concentrations below 5% longer-term, our Walgreens' concentration should decline further in coming quarters. Our weighted average lease term with Walgreens is approximately 10 years with just one lease expiring before 2030, which we believe has virtually zero renewal risk given its exceptionally high front-end sales and its 99th percentile national ranking on Placer for foot traffic. Lastly, while there is nothing to report on this front as of today, we have received a fair amount of inbound interest in our Walgreens locations. Largely from large-format convenience store operators, who are currently willing to pay high rents for high-quality locations similar to the properties that we own. We are also nearing a highly positive outcome as it relates to our Big Lots, which currently stands at 80 basis points of total ABR. As a reminder, prior to 2024, we decreased our Big Lots concentration from 11 stores to 8 stores in order to protect our cash flow in the event a financial restructuring occurred, which indeed happened this September. Of the eight locations, one was assigned to Ollie's Bargain Outlet, an existing investment-grade profile tenant of ours. Another site is being marketed for lease in Bowie, Maryland, where we have received a number of attractive letters of intent from major retailers and grocers. And the remaining six locations have all been assumed by Big Lots. As part of the negotiation, we extended the lease term to an average of 7.5 years, albeit we did agree to provide some short-term rent relief during the bankruptcy process, which we expect to conclude sometime in December. Looking out to 2025, we should experience little-to-no loss in our rental stream from the eight assets while gaining longer lease terms from better credit profiles at proven rents. While we prefer not to have any noise around the health of our tenants' credit, we believe it is important to demonstrate that our underwriting of assets proved to be sound and resulted in minimal disruption to our cash flows. As a reminder, we view corporate credit, unit-level cash flow production, and the fungibility of our real estate as moats of protection around our rental streams. We are not simply buying high-credit quality assets and hoping for the best. Our strong underwriting and asset management capabilities have and we believe will continue to help us generate extraordinarily consistent portfolio cash flow for our shareholders. Lastly, before I hand the call over to Dan, I'm pleased to share that effective October 1st, Lori Wittman was appointed the Chair of the Board of Directors. Lori has been a valued member of our Board going back before our IPO, and she has consistently demonstrated a deep understanding of our business and a commitment to our success. Her continued service will be instrumental as we execute on our strategic vision and long-term growth. With that, I'll hand the call to Dan to go over our third quarter financials and then open up the call for your questions.

Thank you, Mark. Looking at our third quarter earnings, we reported a net loss of $5.3 million or $0.07 per diluted share. Core FFO for the quarter was $24.9 million or $0.32 per diluted share, and AFFO was $24.8 million or $0.32 per diluted share, which was an over 3% increase versus last year. Turning to the expense front. Total recurring G&A declined 16% year-over-year to $4.3 million while recurring cash G&A declined 24% year-over-year to $2.9 million. In addition, with our total recurring G&A representing 10% of total revenues in the quarter versus 15% 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 $569 million. Our weighted average debt maturity was 3.3 years and our weighted average interest rate was 4.46%. Including extension options, which can be exercised at our discretion, we have no debt maturing until January 2027. At quarter-end, our liquidity was $464 million, which consisted of $29 million of cash-on-hand, $250 million available on our revolving credit facility, and $185 million of unsettled forward equity. Turning to leverage. Our adjusted net-debt to annualized adjusted EBITDAre was 4.0 times at quarter end, which remains well below our targeted leverage range of 4.5 times to 5.5 times. Moving on to guidance. We are maintaining our 2024 AFFO per share guidance midpoint and updating the range to $1.26 to $1.27 from our prior range of $1.25 to $1.28. Lastly, on October 18, the Board declared a quarterly cash dividend of $0.21 per share. The dividend will be payable on December 13 to shareholders of record as of December 2. Based on the dividend amount, our AFFO payout ratio for the third quarter was 66%. With that, operator, we will now open the line for questions.

The first question comes from Wes Golladay with Baird. Please go ahead.

Hi, good morning, guys. As you look into the fourth quarter and maybe the first quarter of next year as you're shedding some of your non-core assets, do you still expect to maintain an accretive acquisition spread versus your dispositions?

Yes, we do, Wes. I think just looking forward to the fourth quarter and maybe early in the first quarter, where we have some visibility, we expect cap rates to stay pretty close to where they are right now, maybe slightly below where we've been for the first three quarters, but the dispositions that we're looking at currently are at lower cap rates than what we achieved in the third quarter.

Okay. And then how do you see your Dollar General exposure progressing over the next year or so? And then can you comment on the quality of your locations? You gave a nice little analysis about your Walgreens being Blend & Extends and high foot traffic, but can you maybe unpack the Dollar General exposure?

Yes. Sure. So, yes, the Dollar General portfolio that we have, I think is a little bit unique. In that, we were able to partner with the tenant and get most of our leases extended, and then really the ones that weren't extended, we've gone out and sold the vast majority of those. So we're left with just under 15 years of weighted-average lease term with an average of 1% annual increases in the leases. So a little bit unique when you compare our dollar store portfolio to others. But yes, I mean, there are a number of loans in there. So I think those will get paid off here in the next year or so. So that really kind of brings the concentration down below 10% just with that. And then, we are looking at a handful of dispositions just to try to get that concentration down a little bit, which I think will certainly be well below 10% here in the next couple of quarters.

Okay. Thank you.

Thanks, Wes.

Thank you. Next question comes from the line of Haendel St. Juste with Mizuho. Please go ahead.

Hi, good morning. This is Ravi Vaidya in the line for Haendel. I hope you guys are doing well. So the drugstore and pharmacy exposure decreased 160 basis points sequentially. Can you offer some comments on the disposition market and maybe also the element of seller financing when addressing the Walgreens dispositions? Is this something we should be expecting going forward? Thank you.

Thanks, Ravi. The dispositions market has improved a bit. As many of you know, the 1031 market dried up over the past year, but it is starting to recover. We're seeing increased interest in our assets. Regarding our success in quickly reducing our exposure in the pharmacy sector, we utilized seller financing for a couple of transactions in the third quarter. The strategy was to secure an interest rate slightly above the cap rate at which we sold the assets, helping us maintain a healthy yield. These were assets where we believed the rent was somewhat above market, so we reduced our exposure more than the perceived excess in rent. While we do not anticipate using seller financing frequently in the future, we may consider it if it leads to better outcomes. Specifically for the Walgreens, in the third quarter, the average cap rate was around 7.2%, and the interest rate was marginally higher. We view that as a favorable outcome. However, in the fourth quarter, we have managed to sell additional assets without employing seller financing, which is likely the direction we will take going forward.

Got it. That's helpful. Helpful color there. Just one more here. What would you say is a steady acquisition run rate for the next five, six quarters on a longer-term basis, particularly given the fact that outstanding equity has decreased and the current weighted average cost of capital is a bit elevated?

Yes. Look, I mean I think if given where our cost-of-capital is today, we're not able to achieve sufficiently accretive spreads to acquire at the pace that we're acquiring at today. So I think it just remains to be seen what our run rate would look like. I think the team is certainly built to do anywhere from net investment activity of $100 million to certainly $150 million, right now, though, we do have plenty of capacity to continue to invest. And I think as we see our cost of capital season over the next couple of quarters, we'll think about how that impacts our ability to grow on a go-forward basis.

Thank you.

Thank you. Next question comes from the line of Smedes Rose with Citi. Please go ahead.

Thanks. It's Nick Joseph here for Smedes. Sorry if I missed it, but just on the Big Lots, understand the additional term there, but from a cash rent perspective, what's the rent difference going forward versus what was in the previous leases?

We have one location that is being marketed for lease. We are in discussions with various retailers and grocers. We believe the rent will be at least at the current level or slightly higher, similar to what it was before the bankruptcy.

Thanks. And for the existing leases that will continue with Big Lots?

Yes. There is a small amount of rent decrease there including we're not collecting rent here during the bankruptcy period. But I think the increase in the rent that we're likely to get for the Bowie site will likely offset that.

Got it. Thank you. And then just on the acquisitions, obviously, the proportion of investment-grade came down in the quarter, you mentioned, on the sale-leaseback. What are the expectations for that percentage going forward as and would you expect to see more investment-grade acquisitions kind of in the future quarters? And if so, how are you thinking about cap rates there that would make them more attractive versus what you saw this previous quarter?

Yes, Nick, and that's exactly what was really kind of driving our decisions around what we were acquiring in the second and third quarter. We just saw much more attractive risk-adjusted returns on the larger operators that might not have an investment-grade rating, certainly, not going out and doing a lot of the small deals with four- or five-unit operators, but still larger operators that we're comfortable with where we're getting really strong unit-level economics and replaceable rents. And so that has been an area where we've been pretty successful with. I would expect the fourth quarter to see that investment-grade kick up a little bit higher than it's been in the second and third quarter.

Thank you very much.

Thank you. Next question comes from the line of Ki Bin Kim with Truist Securities. Please go ahead.

Thank you. Good morning. Could you provide an overview of the expected cap rates for the remaining asset sales related to Walgreens and Family Dollar? What is your ultimate goal in terms of reducing the percentage of ABR from these types of tenants?

Thank you, Ki Bin. Regarding Family Dollar, as you know, we have been reducing our exposure over the past few years, starting with assets that were either unprofitable or not very profitable. Currently, we have a portfolio of Family Dollar locations that generate positive cash flow, and we believe they are good stores. However, we plan to continue selling down that exposure over the next year or so, and it now represents just over 1% of our ABR. On the topic of Walgreens, as I mentioned earlier, we have reduced our exposure from 5.9 to 4.8 relatively quickly. We expect to continue this trend, although perhaps not as rapidly as in the third quarter, and we aim to bring it down below 3% within the next six or seven quarters.

And on pricing, if you can provide some parameters, please?

Yes. Sure. So I mean, we were able to sell the Walgreens in the third quarter at a lower cap rate than our disposition cap rate. And so that is encouraging. We just know that we're going to have to take our time to find the right buyers to understand that these are stores that are unlikely to be closed. And we feel like we can continue to see pricing certainly inside an eight.

Okay. Thank you.

Thanks, Ki Bin.

Thank you. Next question comes from the line of Kathryn Graves with UBS. Please go ahead.

Hi, good morning. Thank you for taking my question. So acquisitions obviously accelerated in the quarter. I was wondering if you could speak a little bit on how you're characterizing the current transaction environment, especially compared to the first half of 2024, both as far as maybe increasing opportunities, but then on the flip side, maybe increased competition for deals?

Yes. We've definitely noticed that opportunities have increased significantly compared to earlier this year. While we expect competition to rise, we haven't encountered much of it in our search for locations. The main challenge has been seller expectations over the last year, and that situation remains unchanged. However, we are observing strong prospects in investment-grade transactions, sale-leasebacks, Blend & Extend agreements, and development projects. Overall, we are optimistic about the opportunities we see; it will mainly depend on our cost of capital.

Got it. That makes sense. And then my second question, you mentioned in the prepared remarks about sort of getting ahead of Big Lots prior to 2024. I'm wondering if you can speak to any current consumer trends or other components of proactive portfolio management that you're monitoring right now.

Yes, certainly. Lower-income consumers have been facing challenges, and this pressure is starting to affect middle-income consumers as well, with job growth also slowing down. Therefore, we are being cautious about consumer spending and ensuring that we invest in businesses that have some protection against these consumer issues. We are also focused on companies with strong balance sheets that can handle disruptions and maintain solid unit-level economics. Overall, it seems to be a bit more challenging than it was a quarter ago, with similar underlying issues.

Got it. Thanks so much.

Thank you. Next question comes from the line of Upal Rana with KeyBanc Capital Markets. Please go ahead.

Great. Thanks for taking my question. Mark, you talked about the relative strength on your remaining Walgreens. How does that differentiate from the two assets you did sell in the quarter?

We believe the assets we sold were valuable, though they had slightly shorter lease terms. We anticipate attention not just on the total annual base rent we have with Walgreens, but also on the lease expiration timeline. Fortunately, we don't have any leases ending before 2030, barring one that has excellent sales and foot traffic, making it very unlikely for them to close that store. We're focused on enhancing our portfolio and extending our weighted average lease term, which increased from nine to ten years this quarter. Upgrading quality is essential. Walgreens is experiencing challenges with drug reimbursement rates, and we are monitoring this situation closely. We aim to be prepared should conditions worsen. While we cannot predict if they will improve or deteriorate, we feel well-positioned if things take a downturn.

Okay. Great. That was helpful. And then, yes, how would you describe sellers at this point in the cycle? Given we've had a 50-basis-point rate cut already and there is a likelihood of another 25-basis-point cut this week, and then we've also seen the 10-year sort of climb higher by over 60 basis points. So I want to kind of get your sense on where sellers are at this point.

Yes, I believe the recent increase in the tenure has reassured some sellers and many brokers who were concerned that it was their last chance to secure favorable cap rates before they dropped. Clearly, that decline is not occurring with the rise in the tenure. Therefore, I think it has become somewhat easier to find sellers who are willing to engage in transactions.

Thank you. Next question comes from the line of Greg McGinniss with Scotiabank. Please go ahead.

Hi, good afternoon. Are you able to give us maybe just a few more details around the non-investment-grade acquisitions that you completed this quarter, whether that's the names, the tenants or some of the deal terms, just so, we can better understand what you guys were doing?

Yes, I can provide more details. The weighted-average lease term in the convenience store segment may be slightly extended, particularly among a few retailers rated BB or BB+, which could potentially be upgraded in the future. Our main focus over the past couple of years has been on boosting the internal growth of our portfolio. Initially, after our IPO, we had about 65 to 70 basis points, and now we're exceeding 1% in internal rent growth. This has definitely been a priority, and the acquisitions made last quarter have contributed to this progress.

Okay. And just a couple of clarifying points. One on the Big Lots rent relief. So is that the full 80 basis points just not paying for what this month, last month, and then expected to start paying again in December? Or how should we think about that?

We expect them to start paying again in January.

January. Okay. Last one for me. There's already been a lot of focus on Walgreens on the call, but CBS is closing stores as well. Have you heard anything from them regarding potential store closures? Or how do you feel about those assets in the portfolio?

Yes, I mean, we feel very strongly that we've got a great relationship with CBS. A lot of the CBS is that we acquired were Blend & Extend transactions as well, and we've got a pretty good understanding as to how they're doing within the four walls of the assets that we own and feel like we've got an exceptionally strong CBS portfolio. And I think the stores that they announced that they were closing, I think was really about 2.5 years ago where they said they're going to close 900 stores over the next three years. So that should really be winding down here in 2024. Thanks, Greg.

Thank you. Next question comes from the line of Josh Dennerlein with Bank of America. Please go ahead.

Hi, good afternoon. This is Farrell Granath on behalf of Josh. I was curious in terms of bad debt, kind of considering your previous levels that you've been assuming, would you ever consider maybe even next year increasing assumptions of bad debt just given headlines and current risk associated with pharmacies and retail in general?

Hi Farrell, it's Dan. The answer is no. I want to point out that we didn't experience credit losses this quarter or this year. We simply provided temporary rent relief. As you consider our expectations for the core portfolio coming out of 2024, the previous model would have taken into account that these credit losses would last indefinitely, but in reality, they are only temporary. Therefore, the core portfolio is actually in a better position than we anticipated when we set our guidance in January.

Thank you. I have one more question regarding the current headlines. I know you discussed the underwriting parameters you've established, but I'm curious if you're being more cautious or requiring additional profit and loss reports from tenants as you continue with your underwriting process.

Yes, thank you, Farrell. I believe we have a solid understanding of how our tenants are performing within the spaces we own. We are cautious about what we include in our portfolio. One lesson we have learned is that having higher concentrations of publicly traded companies, which often generate a lot of news and fluctuations in performance, can negatively impact us. Nonetheless, we are confident that the assets we have added to our portfolio will continue to pay rent and will perform well for the company.

Okay. Thank you very much.

Next question comes from Ki Bin Kim with Truist Securities. Please go ahead.

Hi, thanks. I have a follow-up regarding Walgreens. How do you assess the performance of the Walgreens locations, especially since they are varied and cannot really be compared to the entire chain? What can you tell us about the quality of the Walgreens or Family Dollar stores that you still have?

Yes, we have locations that will remain open, continue paying rent, and are profitable for each tenant. We gather necessary information from the tenant about the lease and maintain a strong relationship with both tenants, which fosters open discussions about their plans for the stores we own. This proactive communication has helped us identify potential closures and risks early on. It's crucial to engage in these conversations not only when acquiring the asset but also continuously through our asset management department. This ongoing dialogue gives us significant confidence that these locations will continue to perform well.

I'm unsure if front-end sales are the main factor compared to pharmacy sales. I'm just interested in that.

Yes.

Do you have an opinion on the four-wall profitability of those locations?

Yes, we are confident that the locations we own are profitable. The profitability issues primarily stem from the pharmacy side, where reimbursement rates have decreased due to factors like Medicare Part D and changes from insurance companies. This has made it challenging for pharmacies, evidenced by a significant reduction in store numbers, such as the cut from 2,400 to 1,200 stores. We've noted that CBS is closing 900 stores, and looking at Walgreens, they're facing similar challenges. Overall, the three largest chains are closing 4,000 stores, and independent pharmacies are even worse off, with over a third likely to shut down. The primary driver of these issues has been reimbursement rates, particularly from government sources and insurance companies. The front-end sales, which only account for 25% of revenue, are under pressure, but they do not determine the profitability of pharmacies.

Okay. Thank you very much.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now like to turn the floor over to Mark Manheimer for closing comments.

Thanks, everybody, for joining today. We certainly appreciate everybody's interest in the company and look forward to seeing many of you at the upcoming conference season.

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