Phillips Edison & Company, Inc. Q2 FY2023 Earnings Call

Good day, and welcome to the Phillips Edison & Company's Second Quarter 2023 Earnings Conference Call. Please note that this call is being recorded. I will now turn the conference over to Kimberly Green, Head of Investor Relations. Kimberly, you may begin.

Thank you, operator. I'm joined on this call by our Chairman and Chief Executive Officer, Jeff Edison; our President, Devin Murphy; and our Chief Financial Officer, John Caulfield. Once we conclude our prepared remarks, we will open the call to Q&A. After today's call, an archived version will be published on our website. As a reminder, today's discussion may contain forward-looking statements about PECO's view of future business and financial performance, including forward earnings guidance and future market conditions. These are based on management's current beliefs and expectations and are subject to various risks and uncertainties as described in our SEC filings, including in our most recent Form 10-K and 10-Q. In our discussion today, we will reference certain non-GAAP financial measures. Information regarding our use of these measures and reconciliations of these measures to our GAAP results are available in our earnings press release and supplemental information packet, which have been posted to our website. Please note that we have also posted a presentation with additional information. Our caution on forward-looking statements also applies to these materials. Now I'd like to turn the call over to Jeff Edison, our Chief Executive Officer. Jeff?

Thank you, Kim, and thank you, everyone, for joining us today. Before we get into our results for this quarter, I would like to acknowledge the recent two-year anniversary of PECO's IPO. I would also like to highlight the progress the PECO team has made during this period and reiterate our optimism for the future and our long-term growth plans. PECO's strategy remains simple and consistent. We exclusively own and operate grocery-anchored neighborhood shopping centers. More than 30% of our rents come from our grocers. On average, customers visit our grocers nearly two times a week. We are 98% occupied, which gives us strong pricing power. Leasing demand is at historically high levels for our in-line spaces, and we have limited exposure to big-box retailers. We are lowly levered with a great balance sheet and well-positioned for accretive acquisitions in a highly fragmented market. These components have not changed. We remain focused on owning shopping centers anchored by the number one or two grocer within a market. Our neighbor base has an omnichannel strategy and more than 70% of our rents come from neighbors selling necessity-based goods and services. Our centers are situated in targeted trade areas with favorable demographics where our top grocers make money and our neighbors are successful. Each of these components remains critical to our success. We continue to believe that format drives results. Our average center is 115,000 square feet, which is the smallest in the REIT shopping center space. This enhances our pricing power. Our smaller centers allow for better FFO growth because they yield higher retention rates and strong leasing spreads. Our retention rates averaged 87% between 2017 and 2021. Today, retention is at 94%, reaching a record high of 95% in the first quarter of 2023. High retention rates result in less downtime and lower tenant improvement costs. Lower capital costs result in better returns. From 2017 to 2020, our average cash leasing spreads were 8.8%, providing a meaningful avenue for NOI growth. Combined, comparable rent spreads for new and renewal leases were 10.1% in 2021. Today, we are executing record high renewal spread rates of 17.7%, new rent spreads north of 25% and 18.9% rent spreads when all combined. At the time of the IPO, PECO's total portfolio occupancy had exceeded pre-COVID levels and was at 96% leased. Today, leased portfolio occupancy is at a record high, 98%. Since the IPO, we have pushed annual rent bumps in our new and renewal leases from 2% to nearly 3% on average. Additionally, our smaller format centers and lower exposure to secondary anchors require less CapEx than other retail real estate formats. Lower CapEx leads to higher AFFO. Over 30 years, we have built a fully integrated operating platform and become one of the nation's largest owners and operators of neighborhood grocery-anchored shopping centers. We continue to deliver on the operating side, which is reflected in our consistently strong financial results. Since the IPO, we have exceeded market expectations for NOI, FFO, and AFFO growth. The quality of our performance is an important differentiator. As a reminder, we define the quality of our performance and our portfolio through the use of the acronym SOAR. This includes spreads, occupancy, the advantages of the markets we're in, and retention. PECO has a strong track record of external growth through acquisitions. We have selectively acquired new assets that fit our focused strategy. At the time of the IPO, we told you our plan was to purchase $1 billion of assets over the next three years. Since then, the markets have changed. We cannot control the market, but we can control our response to them, which remains extremely disciplined and opportunistic. The transaction market continues to be fragmented and sporadic, as we saw with the dramatically lower volume of activity in the first half of the year. While we are currently seeing activity increasing, we believe cap rates are still adjusting slowly in the private markets in response to the higher interest rates. There are still gaps between buyer and seller expectations. As we sit here today, we are reiterating our guidance for $200 million to $300 million of net acquisitions this year. That said, if the market remains inconsistent, as we saw in the first half of the year, we may be at the low end of that range. We have a very disciplined acquisition process. We remain focused on accretively growing our shopping center portfolio at the right price while achieving our acquisition hurdle of a 9% unlevered IRR. For the remainder of this year, we remain confident in our business plan, as reflected in our guidance increase. Looking beyond 2023, we believe our portfolio can deliver mid- to high single-digit FFO per share growth on a long-term basis given our internal and external growth drivers. In addition, we still have one of the lowest levered balance sheets in the shopping center space, which gives us the financial capacity to meet our acquisition objectives. The IPO was a major milestone for our company, but it was just the beginning. We remain focused, motivated, and committed to successfully executing our growth strategy, which we believe continues to generate more alpha and less beta. I will now turn the call over to Devin. Devin?

Thank you, Jeff. Good afternoon, everyone, and thank you for joining us today. The PECO team delivered another solid quarter of growth with same-center NOI increasing by 5.3% and our portfolio reaching new record highs in both occupancy and renewal rent spreads. The consistency of our operating performance is attributable to our differentiated and focused strategy of exclusively owning grocery-anchored neighborhood shopping centers anchored by the one or two grocers in a market and our platform's ability to drive results at the property level for our integrated and cycle-tested team. PECO's leasing team continues to convert strong retailer demand into higher occupancy levels and rents. The retailer demand we continue to see is driven by the positive impact of the macro trends of hybrid work and suburbanization. Our anchor occupancy increased 10 basis points sequentially to 99.4%, and in-line occupancy increased 50 basis points sequentially to a record high of 94.8%, representing year-over-year increases of 70 and 160 basis points, respectively. Leasing activity remained strong, and our volume of deals executed in the first half of the year increased year-over-year to 548 leases totaling over 2.6 million square feet. We continue to capitalize on strong renewal demand and are making the most of the opportunity to strengthen key lease terms and drive renewal rents higher. Specifically, for the second quarter, we achieved a 17.7% increase in renewal rent spreads, an all-time high. In terms of new lease activity, we continue to have success driving meaningfully higher rents in our portfolio. New rent spreads for the second quarter increased 25.1%. We expect that leasing spreads will continue to be strong through the balance of this year and into 2024. Our pricing power is the driver of these metrics, and we do not see this changing in the near term. Our ongoing success in leasing continues to be driven by the strong demand for space across our grocery-anchored portfolio. Demand continues to come from necessity and service-based neighbors. Currently, we see leasing demand primarily from restaurants, health and beauty neighbors, and medical neighbors. Restaurants represent 40% of our leasing pipeline activity today, half of which are quick service restaurants, such as Dunkin' Donuts, Zaxby's, and Firehouse Subs. Health and beauty services are 11% of current leasing demand. Medical or Medtail, as we call it, is a fast-growing use in PECO's neighbor mix, and we continue to see strong demand for medical uses. Medtail currently represents 6% of our ADR, but 20% of our current leasing pipeline. PECO's retention rate remained strong at 94% in the second quarter. High retention rates mean no downtime and less tenant improvement costs, which leads to higher stabilized yields in our assets. As a reminder, our TI spend on renewals over the last five years averaged less than $2 per square foot and averaged just $1.35 per square foot in the second quarter. On average, our new and renewal in-line leases executed in the second quarter had annual contractual rent bumps of 2.6%, another important contributor to our long-term growth rate. We continue to invest in our value-creating round-up outparcel development and repositioning projects, which remain a good use of our free cash flow and deliver attractive returns. Year-to-date, we have stabilized seven projects, delivering over 175,000 square feet of space to our neighbors and incremental NOI of approximately $2.1 million annually. These projects provide superior risk-adjusted returns and have a meaningful impact on our long-term NOI growth. For the full year of 2023, we now expect to invest $35 million to $45 million in ground-up outparcel development and repositioning opportunities with average estimated underwritten cash-on-cash yields between 9% and 12%. We have delayed construction starts for four projects that were originally planned to commence in the second half of this year that will now be pushed into 2024, lowering our expected spend in 2023 by approximately $15 million. We continue to enjoy the many benefits of PECO's grocery-anchored portfolio with our healthy mix of national, regional, and local retailers. More than 70% of our rents come from neighbors offering necessity-based goods and services, and our top grocers continue to drive strong recurring foot traffic to our centers. Our local neighbor health remains strong. Local neighbors, which represent 26% of our ABR, continue to thrive in PECO's portfolio, benefiting from the continued strong foot traffic created by our grocer anchors and the strength of our neighborhood locations. The map behind our local neighbors continues to be positive and is improving. Our local neighbors have been in our centers an average of nine years. This length of tenancy compares favorably to the capital investment average payback period of just 10 months. As of the second quarter, we have retained 78% of our local neighbors, an increase from 76% historically. Renewal rent spreads for our local neighbors were 23% for the quarter compared to 18% for the overall PECO portfolio. In addition to the compelling economics behind our local neighbors, they differentiate our centers and offer a unique merchandising mix for our customers. We want to emphasize that successful local entrepreneurs prosper in PECO's grocery-anchored neighborhood centers. We continue to benefit from a number of positive macroeconomic trends that create strong tailwinds for us and drive strong neighbor demand. These trends include a healthy consumer, hybrid work, migration to the Sunbelt, population shifts that favor suburban communities, and the importance of physical locations in last-mile delivery. These demand factors are further amplified due to limited new supply, given the lack of new construction in our space over the last 10 years and going forward, given the economic returns associated with new construction. I'd now like to turn the call over to John. John?

Thank you, Devin, and good morning, and good afternoon, everyone. I'll start by addressing second quarter results, provide an update on the balance sheet, and then speak to our increased 2023 guidance. Second quarter 2023 Nareit FFO increased 6.7% to $75.9 million or $0.58 per diluted share, driven by an increase in rental income and our strong property operations. Second quarter core FFO increased 8.2% to $77.7 million or $0.59 per diluted share, driven by increased revenue at our properties from higher occupancy levels and strong leasing spreads, partially offset by higher interest expense. Our second quarter 2023 same-center NOI increased to $99 million, up 5.3% from a year ago. This improvement was primarily driven by higher occupancy and an increase in average base rent per square foot, driven by our strong leasing spreads partially offset by lower collectibility reserve reversals in the current period when compared to 2022. From a balance sheet perspective, we ended the quarter with approximately $629 million of borrowing capacity available on our $800 million credit facility. Earlier this week, we extended all of our 2024 term loan maturities into 2026 and 2027. The 2026 term loan has two 12-month extension options that allow us to push the maturity into 2028 at our election. This enhances our already strong liquidity position and maintains our well-laddered debt maturity profile. These term loan extensions improve our debt maturity profile, maintaining our financial flexibility and allowing for a lower cost of capital as we navigate the current debt capital markets. We appreciate the continued support of our banking partners. As we look at our floating rate exposure, 19% of our debt is currently floating and is influenced by our use of the revolver. We plan to limit our floating rate debt to less than 10% of our total debt, and we're currently working on alternatives to meet this target. Our leverage ratio continues to be strong as a result of our solid earnings growth as well as our prudent balance sheet management, with our net debt to adjusted EBITDA at 5.2x as of June 30, 2023. At the end of the second quarter, our debt had a weighted average interest rate of 3.9% and a weighted average maturity of 4.6 years when including the refinancing activity from this week and available extension options, 81% of our debt was fixed rate. Between the free cash flow generated by our portfolio and the significant capacity available on our revolver, we remain confident in our ability to fund our growth plans. Turning to our updated guidance. Based on our performance to date, we are raising our Nareit FFO and core FFO per share guidance. Our new core FFO guidance increased to a range of $2.30 to $2.36 per diluted share. We're also increasing our same-center NOI guidance to a range of 3.75% to 4.5%. These increases are a result of strong property performance driven by leasing spreads, record occupancy, and high retention. With that, we look forward to taking your questions. Operator?

Your first question comes from the line of Caitlin Burrows of Goldman Sachs.

I know addressing your 2024 debt maturities was a goal of yours for this year. So congrats on getting that done. Now your weighted average maturity of debt is 4.6 years, up from 4.1. So maybe you could talk a little bit about your outlook and opportunity from here regarding kind of the ability to extend that further.

Sure. We worked on a significant project and are very thankful for the support of our lenders, which has allowed us to progress and provides us with flexibility given the limited resources we have for our acquisition plans for the rest of the year. We are continually assessing additional financing options to help us extend further. We are optimistic about the bond market and expect to see more activity there. While base rates are higher, we aspire to be a long-term unsecured bond issuer, but we also have the option to explore secured markets or other financing methods available to us.

Okay. And maybe just on the acquisition side, I think that's a unique earnings driver for PECO versus peers in particular, but the lower transaction volumes year-to-date for the industry and for PECO has limited that positive driver. So I guess could you talk about how the transaction opportunities have developed year-to-date, kind of the pace of deals you're seeing, what you've worked on, what you've passed on, and kind of your expectation for finding attractive opportunities in the second half.

Sure, Caitlin. I apologize for my initial response. I was muted, but John provided a solid answer. As you're aware, the acquisition market is challenging right now. We're pleased to have acquired $80 million worth of properties in the first half of the year. We've maintained strict discipline in our underwriting criteria, ensuring that we target properties with the leading grocers where we can effectively increase rents and occupancy. We plan to uphold this discipline, and we believe the market is beginning to loosen. We're observing greater price recognition compared to the last one and a half quarters. Overall, I would say we're cautiously optimistic about our acquisition activity in the latter half of the year. However, it is still early, and there are many variables that could influence our outcomes. In the short term, over the next couple of quarters, there's considerable uncertainty about where we might land. Furthermore, we currently have one small project under contract that will likely close in the next couple of weeks. We have significant work ahead, but we feel that the market is trending positively for us to achieve our objectives. John, do you have any additional thoughts on this?

No, nothing to add.

Your next question comes from the line of Jeff Spector of Bank of America.

Just a follow-up on the acquisitions, I'm sorry if I just missed this, but did you provide specifics on, I guess, where cap rates are versus again, what you're looking to acquire at? Like how has the gap been narrowing?

Thank you for the question. We haven't specifically discussed the narrowing yet. We believe there has been a movement of 50 to 100 basis points in cap rates. Our primary focus is on achieving long-term returns and ensuring that our acquisitions contribute positively early on. Attaining an unlevered IRR in the current environment is challenging. However, as cap rates have adjusted and sellers have recognized the new pricing, we're seeing an increase in available properties. This should help us reach the acquisition range we've mentioned. I would estimate that the 50 to 100 basis points movement in cap rates is a reasonable approximation, though there is a wide variance in these factors. Generally, for an average property, this provides a solid way to assess where the pricing has shifted.

Okay. And then the second question is on the gap between leased and economic occupancy. It narrowed this quarter to about 60 basis points. How should we think about that for the second half of the year into '24?

Sure. Jeff, our long-term historical average has been 60 basis points, although it has widened at times, reaching up to 100 basis points in the past year. However, it's generally consistent around 60 basis points. This consistency is largely due to the fact that most of our new leasing is in line, allowing us to get those spaces up and rent-paying more quickly than if we had more box activity. Looking ahead, I believe that 60 basis points is a reasonable expectation.

Your next question comes from the line of Ronald Kamdem of Morgan Stanley.

Congrats on the quarter. Just two quick ones for me. Just back to the debt extension that you executed for '24. Maybe is there a way to quantify once you annualize what the interest cost delta is going to be in '24 versus '23, now that you've extended those pieces? How should we think about that?

John, do you want to take that one?

It depends on the assumptions made regarding acquisitions in 2024. We believe the 2023 figure is valid, but considering the rate increases and if the acquisitions are funded with debt, we anticipate an increase of about $15 million.

I appreciate the insight. Regarding the acquisition question, it seems that the decrease in acquisition and development spending has led to some project delays. Can you provide more details on this? Were the costs simply too high, or was there another reason for the delays? I would like to understand this better. Additionally, on the acquisition side, I’m curious about what you believe is making it challenging to secure deals. Are you being outbid, or is there just not enough activity in the market? I'm trying to figure out how to encourage more transactions.

Yes. Dev, do you want to take the development and I'll cover the deal side on the acquisition?

Sure. Ron, on the redevelopment delays, there are basically four projects that were pushed from '23 into '24, and the reason varies by project, but it comes down to one of several things: either, a, entitlement delays or b, material delays or c, the need for the neighbor to wait to start. Like, for example, one of these projects was the Publix in the portfolio; they did not want the store to be closed during the holiday season, so they pushed it into early '24. So it's a combination of factors, but it has nothing to do with the kind of returns that we can achieve on these projects. We still continue to believe that we can do $50 million to $60 million of this activity on an annual basis on a go forward, and that these projects will deliver cash-on-cash returns of 9% to 12% on average. So it's a very attractive use of capital given the risk-reward of these activities.

Does that address your question about the redevelopment? Regarding acquisitions, the current challenges with transaction volume are typical during a period of market repricing. Sellers are reluctant to accept the new prices while buyers believe prices might drop further. We're navigating this phase, and it's a familiar pattern that has occurred in the past and will occur again. Generally, when interest rates rise and capital costs increase, pricing tends to widen, requiring sellers to adapt to new pricing, while buyers expect further adjustments. This situation has led to a spread difference of about 50 to 100 basis points. We've adjusted our targeted unlevered internal rate of return from 8% to 9%. Although this adjustment may take time, it is happening slightly faster than we anticipated. We expected a more gradual progression than what we are currently experiencing, which we hope will help us meet and exceed our acquisition expectations for the year.

Your next question comes from the line of Juan Sanabria of BMO Capital Markets.

Just a question on the balance sheet. You guys have done a good job taking leverage down over time. So how should we think about you funding future acquisitions as the attention to lever up or to fund it kind of with an equity debt mix to keep leverage closer to where it is today? And as part of that, John mentioned reducing the floating rate exposure. So just curious on what the options there are.

Okay. I’ll address the first part of your question, and then you can share your thoughts on managing the debt. Juan, we are very focused on aligning our cost of capital with our acquisitions. You can expect us to maintain an unlevered balance sheet so we can actively acquire when the timing is right. This is the discipline we've demonstrated this year and will continue to uphold, using our balance sheet strategically but only in favorable markets where we can secure accretive growth properties that allow us to create significant value. In simpler terms, we will monitor the debt markets and act when the equity markets are conducive. As you know, we accessed our ATM last year when we identified a favorable spread between our cost of capital and our purchases, which we deemed appropriate at the time. We continuously evaluate this balance. John, would you like to discuss our strategy regarding fixing rates?

Before we go to John regarding fixing rates, I want to remind Juan that we generate over $100 million each year in free cash flow after dividends, which allows us to acquire $250 million in assets annually with that cash flow. Our funding requirement arises when our acquisitions exceed $250 million a year. Additionally, our balance sheet currently shows a debt to EBITDA ratio of 5.2x, indicating that we have leverage capacity. Therefore, for any amount beyond that $250 million, we would typically utilize our leverage capacity to facilitate those acquisitions.

Yes. The $250 million Devin mentioned indicates that we can acquire that amount without increasing our leverage, while we have a long-term leverage target of around 6x. In the current environment, we are making use of our low leverage, which is advantageous. However, with the available opportunities, we would consider increasing that amount. Regarding the choice between floating and fixed rates, we are currently favoring floating rates. At the end of the quarter, we had approximately $168 million in liquidity. The term loan financing provides us with flexibility during this period, allowing us to assess the direction of treasury rates and the elevated spreads in the market due to uncertainty. The term loans enable us to wait for a more opportune time to access the debt capital market, which informs our strategy regarding fixed instruments. We also have an $800 million revolver at our disposal. Our long-term objective is to keep less than 10% of our debt floating. If we pursue our acquisition target for the year and finance it with fixed instruments, that will help us move towards that 10% goal, and ideally align more closely with our peers in terms of fixed debt.

I have a follow-up question regarding bad debt. You've lowered the guidance, and it appears you're leaning towards the lower end of that revised range. I'm interested in the assumptions that underpin both the high and low ends of the bad debt range. Is there an expectation of further economic deterioration at the lower end of that range? I would appreciate any insights you can provide on this matter.

John, do you want to take that?

Historically, this portfolio has generated between 16 and 80 basis points of revenue over a long period. We are currently seeing positive trends due to the strength of the consumer and our neighbors. As we look toward the second half of the year, we anticipate continued strength, although we may not be forecasting as optimistic a outcome as we did for the first half. Disruptions are probably less factored into the bad debt numbers because they are relatively tight, and it's something more considered within the FFO range we provide. Based on our observations in areas like retention, leasing, and collections, we are not witnessing any signs of decline. Therefore, we remain optimistic about the second half of the year.

Next question comes from the line of Mike Mueller of JPMorgan.

My question was answered; tried to get out of the queue. Thank you, though.

Your next question comes from the line of Haendel St. Juste of Mizuho.

This is Ravi Vaidya on the line for Haendel. I hope you guys are doing well. I just wanted to ask here with the portfolio nearly full and minimal bankruptcies and now limited acquisition volumes going forward. Where do you think the incremental source of growth will be coming from? Do you think you'll be able to continue to push renewal rents and similar spreads going forward? What do you estimate the current mark-to-market opportunities within your portfolio?

Thanks for your question, Ravi. There are two main drivers of our growth. First, we focus on internal growth, which comes from increasing our rental streams through contractual rent increases and achieving strong re-leasing spreads while minimizing capital expenditures and maintaining a high retention rate. This internal growth will rely less on occupancy increases and more on our pricing power to raise rents, and our numbers reflect that we expect this trend to continue. We believe there is still potential for an increase of 50 to 150 basis points in small store occupancy, and we are actively working on achieving that. Looking ahead, we’re confident those growth engines will remain in place. Additionally, our readout work is proving to be very beneficial and contributes positively to our growth, supported by a solid balance sheet that allows for external growth as well. When we combine these factors, we believe we can achieve mid- to high single-digit annual growth in our core funds from operations. The operating environment, along with the tailwinds mentioned by Devin in his remarks, are creating a solid foundation for growth. I'm optimistic about our prospects moving forward. Importantly, I want to reassure everyone that we are not noticing any signs of market distress; it does not seem like we are heading into a significant downturn. Devin, if there's anything you'd like to add, please go ahead.

Yes. I mean, Jeff, what I would say, Ravi, we think that this portfolio on a go-forward can generate same-store NOI growth of 3% to 4%, and we realize that the growth that we've been getting in that same-store NOI number from occupancy is going to go down, and we're getting closer to an occupancy level where it will no longer contribute to same-store NOI growth. That will be replaced by the growth we will get from new and renewal spreads, which in the second quarter was 150 basis points of our NOI growth. And over time, we think that will be 100 to 125 basis points. Then contractual rent increases will contribute 75 to 100 basis points. And then lastly, redevelopment will contribute 75 to 125. So even without the growth in same-store NOI created by occupancy uplift, we still get to that 3% to 4% same-store number with those other three elements of growth.

Very helpful. Just one more here. Do you have any update with the Albertsons Kroger merger and any update regarding the potential store closure impact?

We don't have any updates to share at this time. We still believe that the merger would be beneficial for us, and we don't see any negative aspects in the potential outcomes. We are monitoring Albertsons' stock as an indicator of the market's perception of the merger's likelihood, as it is still trading at a 20% discount to the strike price. There is still considerable uncertainty surrounding the situation. We're receiving various pieces of information, but nothing suggests that it's either highly likely or unlikely to happen. Management appears to indicate that the merger is progressing normally, which doesn't guarantee its success but reflects a standard procedure for significant mergers, especially in a climate where there is considerable governmental pushback. It's worth noting that the government recently lost a significant case involving Microsoft, indicating that not everything is in favor of the government. I believe both Kroger and Albertsons are confident that the merger will proceed, and they have maintained this position.

Jeff, but on Ravi's question regarding closures. What we've been advised is that in order for the merger to be approved, there will not be store closures that occur as part of the merger generally, and then specifically to the PECO portfolio, we're confident that there would be no store closures in our portfolio because as we look at the productivity of these banners in our portfolio, from a sales per foot and the health ratio, they are viable grocery locations. And so we're confident that there will not be any closures in the PECO portfolio as a result of that merger.

Your next question comes from the line of Todd Thomas of KeyBanc Capital Markets.

A couple of questions. First, I just wanted to clarify quickly. Jeff, your comments about asset pricing. You mentioned 50 to 100 basis points. I think I also heard 150 basis points in response to a question. Were you speaking to cap rate expansion or the spread that you require for new investments versus your cost of capital? Or something else entirely? Can you just clarify what you're speaking to and...

I apologize if I wasn't clear. When I mentioned 50 to 100 basis points, I was referring to the increase in the cap rate. The mention of 100 basis points pertains to the increase in the unlevered IRR that PECO has incorporated into our underwriting as we consider new opportunities. Those are the two key figures. I'm unsure about the reference to 150 basis points, as I don't know where that came from. However, we did increase the unlevered IRR by 100 basis points and believe there is a 50 to 100 basis point increase in the cap rates.

Okay. Got it. And are you still seeing cap rates expand a bit today? Or have they stabilized a bit more recently?

I would say that we believe that there probably is some more expansion in the cap rates, but it's minor compared to what's happened so far in our opinion. Now if rates stay higher for longer, that could change. But our belief is that we've seen the major change from here; it will be more adjustments than it will be any kind of major change in cap rates.

Okay. And then you talked about the high retention across the portfolio, almost 94% again this quarter. Do you expect that to hold in '24? And particularly with regard to the 71 anchor lease expirations, any thoughts there? Any early indications on what you might expect around the anchor expiration specifically?

I don't know if Devin or John, do you want to take that one on those specifics.

I mean, I would just say, Todd, in terms of retention, we have seen fairly consistent retention rates over the last year, varying from a low of 89% to a high of 95%. So the 94% is at the higher end of the range. But we believe that our retention rates are going to be fairly stable because we continue to see very strong retailer demand for our product type. And so we're not expecting to see a material move in that retention rate relative to what we've seen historically. That was an overall retention rate, Todd. And then on the anchors, it's varied between a low of 98.7% and a high of 100%. So again, it's between 99% and 100%. So we're pretty confident that that rate will be consistent going forward. Again, given the productivity that we're seeing out of our anchors and the kind of health ratios that we're seeing from them, the combination of those factors lead us to be confident that they will all exercise renewals or options that they may have.

Okay. There was an article this morning discussing Amazon's growth in the grocery sector. While they've experimented with different formats, their expansion in grocery has been somewhat limited and unclear over the past few years. I'm curious if you have any thoughts on their potential to increase their footprint, what that might entail, and how it could affect the grocery market and possibly your portfolio as you consider this potential expansion.

Yes, that's a great question. We have been looking at Amazon's grocery concept since they launched it. They have significant challenges ahead. It's important not to underestimate Amazon, but so far, they haven't established a unique strategy that makes them more efficient than traditional grocery stores. While having a new store is positive, their current stores are quite similar and don't offer anything compelling that would draw customers away from competitors. They need to demonstrate that they can create a shopping experience that makes consumers choose them over places like Kroger. Currently, they haven't achieved that, and without a proven format, they don't pose a serious threat on a larger scale. Their existing stores aren't generating profit, and reports indicate weak sales figures. They need to develop a way to differentiate themselves, which they have not managed to do yet. Until they find that, we remain cautious about Amazon, as they have the potential to be impactful, but there's a lot of uncertainty regarding their grocery segment. There have been persistent rumors about them acquiring parts of Kroger and Albertsons, but they aren't even opening the stores they are committed to. They have a significant amount of work ahead to successfully enter that market.

Your next question comes from the line of Dori Kesten of Wells Fargo.

When you look at your watch list, I know it's relatively small at this point, but would you imagine your '24 bad debt looks close to your long-term average? You say the 60 to 80 basis points.

Yes, Dori, we believe that it will align with our projections. We don't anticipate any significant issues since our exposure to major brands outside of our grocery partners is quite limited. Therefore, we don't foresee any factors pushing us beyond a typical category performance. Of course, a major recession could change that, but historically, we've performed well relative to others in our space during the last two recessions, experiencing minimal occupancy losses. This success can be attributed to our focus on necessity-based goods and our emphasis on grocery.

Your next question comes from the line of Floris Gerbrand Van Dijkum of Compass Point.

You continue to impress me because I think your anchor occupancy is the highest in the industry. I’m not sure how many vacant spaces you have, but it must be very few. Your shop occupancy also seems to be the best in the sector. This clearly affects your potential for increasing occupancy, especially on the anchor side. Can you share your thoughts on how much more you could realistically increase shop occupancy? Additionally, it seems the fundamentals for retail are very strong right now, with almost no new supply. However, as you know, the market is always changing. How much do you believe rents need to increase in your markets for new construction to be warranted?

Floris, thanks for your question. We think we have another, as Jeff said, 50 to 150 basis points of occupancy uptick there. We realize that, that then impacts our same-store NOI growth, which we continue to believe will be 3% to 4% going forward because the loss of same-store NOI growth created by occupancy will be replaced by our ability to continue to push rents. And so we think the components of our same-store NOI growth going forward, our new and renewal spreads at 100 to 125 basis points. In the second quarter, that metric was 150 basis points. Contractual rent increases will contribute 75 to 100 basis points of growth, and then the contribution of our redevelopment activity at 75 to 125 basis points, which gets you to that 3% to 4% same-store metric.

Yes. Floris, to add to that, there are specific markets where some regional grocers are expanding. If you look at Hy-Vee, Publix, and HEB, they are opening new stores in particular areas. However, these are the regions where we need to be cautious about incoming competition. We compete within a three-mile radius around our centers, with each being its own market featuring its own competitive landscape. Therefore, success in these areas is crucial. Development isn't occurring in most of the markets we operate in, but we remain vigilant, as it varies specifically by the stores we have. One factor we consider is the rental prices needed for new developments. In urban and major markets, rent prices are closer to being feasible for development compared to some of our current markets. As a result, new developments are more likely to take place in those areas rather than the ones we are situated in. In our centers located in Atlanta, Tampa, and Orlando, we expect new developments to be concentrated in denser urban areas that can command rents justifying new construction.

I noticed that your NOI margins decreased slightly during the quarter. They remained relatively consistent during the first six months. Can you provide any insights on whether this is due to increased expenses or something else? Is this related to the previously uncollected rents from last year that contributed to the decline?

We're talking about 30 basis points here. So 72.4% in the quarter, 72% on the six months, I mean I think at that point, it's really the 72% margin is where we see it. I mean, expenses are going to move. But I think that's a good run rate, and it's still very strong.

That's it. And by the way, that also shows your ability to run your business.

Thanks, Floris. We appreciate it.

This concludes our question-and-answer session. I would like to turn the call back to Jeff Edison. Jeff?

Thank you all for joining the call today. We had a strong quarter with same-store NOI growth of 5.3%, record occupancy for both our anchor and in-line stores, and no significant issues with leasing. We managed to acquire $80 million in the first half of a challenging year and market. Additionally, we improved our balance sheet by increasing our debt to EBITDA ratio, extending our loan maturities to 2025, and materially to 2027, which provides us with the necessary flexibility. We expect to continue delivering strong results through 2023 and 2024 while focusing on solid internal and external growth. Thank you again for being on the call, and have a great day.

Thank you. This concludes today's call. You may now disconnect.