Earnings Call Transcript
Phillips Edison & Company, Inc. (PECO)
Earnings Call Transcript - PECO Q3 2022
Operator, Operator
Good day and welcome to the Phillips Edison & Company's Third Quarter 2022 Earnings Conference Call. Please note that this conference is being recorded. I will now turn the conference over to Kimberly Green, Vice President of Investor Relations. You may begin.
Kimberly Green, Vice President of Investor Relations
Thank you, operator. Thank you everyone for joining us today for Phillips Edison's third quarter 2022 earnings conference call. Once we conclude our prepared remarks, we will open the call to Q&A. After today's call, an archived version will be published on our Investor Relations website. I'm joined on this call by our Chairman and Chief Executive, Jeff Edison; our President, Devin Murphy; and our Chief Financial Officer, John Caulfield. As a reminder, today's discussion may contain forward-looking statements about the company's views 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, specifically in our most recent Form 10-K and 10-Q. In our discussion today, we will also 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 we posted to our Investor Relations website. Please note that we have also posted a presentation on our website with additional information. Our caution on forward-looking statements also applies to these presentation materials. Now, I'd like to turn the call over to Jeff Edison, our Chief Executive Officer. Jeff?
Jeff Edison, CEO
Thank you, Kim. Thank you, everyone, for joining us today. Our differentiated and focused strategy of owning grocery-anchored neighborhood shopping centers, together with our integrated operating platform have delivered another strong quarter with same-center NOI growth of 4.3%. This performance has allowed us to raise the midpoint of our 2022 guidance for the third quarter in a row. As reflected in our results, 2022 has been a year of reaching record highs in occupancy and releasing spreads. A strong leasing environment and our current positive momentum are evidence of tailwinds for us that we believe will continue as we head into 2023 and beyond. This provides us with confidence in our ability to successfully execute our growth strategy and continue to deliver strong results. As we've discussed, our grocery-anchored neighborhood centers continue to benefit from structural and macroeconomic trends that create strong tailwinds. These include: population shifts from urban to suburban communities; the increase in hybrid work; the importance of physical locations in last-mile delivery; low supply and lack of new construction; wage growth; student debt relief and low unemployment; and most importantly, the retailer's recognition of the benefits to them of being located in growing suburban markets. Looking ahead, inflationary impacts on the consumer, combined with higher interest rates introduce uncertainty. However, as we reflect on the resiliency of our portfolio throughout the pandemic, combined with the aforementioned tailwinds, we believe PECO's portfolio is well positioned for a recession. This resiliency comes from the following. Our grocery-anchored and necessity-based neighbor mix, our right-sized format and well-positioned locations in growing markets, our record high occupancy with continued strong neighbor demand, our talented and cycle-tested team, our strong credit neighbors and diversified mix, our lack of big box exposure and the lack of distressed retailers in our portfolio. With regards to our growth profile, we expect future organic growth to come from continued increases in occupancy, contractual rent increases and our pipeline of redevelopment and development activity. PECO also continues to be well positioned to capitalize on external growth through new acquisition opportunities as they arise. Currently, we are seeing cap rates expand, with borrowing costs increasing and the volatility in the equity markets, we have moved up our targeted return for new acquisitions to an unlevered IRR of 9% and above. Acquisitions are a key part of our long-term growth strategy and we will continue to participate in the market, while exercising an appropriate level of caution. As we've said our focus is on cash flow and earnings per share growth. We will ensure acquisitions will be accretive to earnings and we will continue to evaluate each acquisition with the same diligence we have always exercised. I know everyone is looking for signs of weakness in both the market and with the consumer, but we are not currently seeing it in our grocery-anchored portfolio. We continue to enjoy solid growth despite the headwinds. We have a great balance sheet, low leverage and strong occupancy. We are located in markets that are growing and have a strong competitive advantage, with our resilient grocery-anchors and necessity-based neighbors. I would like to briefly comment on the recently announced proposed merger between Kroger and Albertsons. Based upon what we currently know, we believe that overall this is positive news for PECO. With an expanded footprint post merger, we will see our largest neighbor become stronger and more profitable. Following the merger, these grocery stores will be managed by an operator, who has generated higher sales productivity at the store level, invest in their physical stores and has a proven ability to drive strong customer traffic to our centers. As we specifically think about the impact of this merger on our portfolio, remember, our strategy is focused on owning centers anchored by the number one or two grocer within a market. So we do have a number of stores that are potentially impacted. We have eight stores located within one mile of another store, 15 stores within one to two and 10 stores within two to three miles. In total, there are 33 stores located within three miles of another store. These 33 stores are productive locations as demonstrated by the following. Their average store sales are $35 million or $620 per foot, which compares to PECO's average of $6.38 per square foot and an average health ratio of 2.1%, which is a key indicator of profitability for the locations. As you can see, these are strong and viable grocery stores. It's still very early. We will continue to carefully evaluate the potential impact to PECO. As we learn more, we will update the market accordingly.
Devin Murphy, President
Thank you, Jeff and good afternoon everyone. Thank you for joining us. The PECO team, supported by the strength of our neighbors, continues to drive outstanding operating results. We are excited about our record occupancy level of 97.1%. And as you can see, these occupancy levels are driving immediate and measurable growth in our financial results. We continue to see 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. Throughout 2022, we have seen our grocers continue to strengthen their businesses. Year-to-date, through September 30, US grocery sales grew by 8.4% and margins are holding. Grocer sales are expected to continue to grow in 2023 and our top grocers continue to drive strong recurring foot traffic to our centers. Our in-line neighbors continue to be successful in our centers. On a trailing 12-month basis, our average in-line neighbor health ratio is 10%, which we believe is healthy and demonstrates that retailers can operate profitably in our centers. Third quarter foot traffic at PECO centers remains strong and is generating healthy sales levels for our neighbors. Our record high occupancy levels provide us pricing power to continue to grow rents at attractive rates. With good health ratios, record occupancy and strong foot traffic trends, we do not see any signs that we will not be able to continue to push occupancy and rents higher. As you know, 25% of PECO's ABR is derived from local neighbors. 64% of our local neighbor rents come from retailers, offering necessity goods and services. Our local neighbors are successful businesses run by hard-working entrepreneurs. 30% of our local neighbor rents come from personal services, such as beauty and hair care. Personal services is one of the most stable uses in our centers. These neighbors pay market rents, renew at attractive rent spreads and demand less capital. Our local neighbors are unique and successful retailers. One example of the unique PECO local neighbor is the backyard kitchen and cocktails at our Murphy Marketplace Center located in Murphy, Texas. This neighbor is the winner of Texasliving Magazine best patio and bar. Also included in our local neighbor category are medical neighbors, including dentists, chiropractors and physical therapists. Medtail as we call it, is a growing use in PECO's local neighbor mix and currently represents 12% of our local ABR. Our local neighbors are resilient and have been in our centers an average of 8.7 years. This length of tenancy compares favorably to the capital investment payback period of just 10 months. Over the last three years, we have retained 76% of our local neighbors. And when we did replace them the average re-leasing spread was 14% on a trailing 12-month basis. In summary, our local neighbors are less expensive to put into spaces, have higher retention rates, achieve renewal spreads similar to nationals and offer an attractive economic package. We believe in the strength and resiliency of our local neighbors and we have added new slides to our investor presentation to highlight these neighbors. In addition to the compelling economics behind our local neighbors, they also differentiate our centers and provide a unique attraction for customers. As we have said before successful local operators prosper in our grocery-anchored neighborhood centers. As Jeff mentioned earlier, smart retailers are taking advantage of the growth available in secondary markets. According to recent Placer.ai data insights, migration changes since 2018 have flipped the script and made these markets appealing for many retailers. Suburban markets are gaining at the expense of major urban markets with suburban markets seeing higher growth. According to Placer, our suburban markets offer retailers several advantages in today's environment including: one, comparable if not superior visit per location trends when compared to larger markets; two, less competition; three, greater diversification of customer base; four, easier access to labor as an employer of choice within a market; and five, less expensive build-out costs. These metrics result in higher-margin stores which are more profitable to the retailer. National retailers such as Chipotle are raising their long-term store-based targets in our markets because these locations have proven to deliver the same or better store level economics. In addition, retailers such as Chipotle, Petco, Kohl's and Shake Shack saw higher visits per location in suburban markets compared to the top 25 MSAs according to the Placer data. Since 2018, the combined number of national neighbors including Chipotle, Dunkin' Donuts, Starbucks, Five Guys, Jersey Mike's and Wingstop in PECO's portfolio increased by 40% evidencing this trend. During the third quarter, we executed first-time deals with national neighbors including Shipley Do-Nuts at Coppell Market Center in Coppell, Texas and Pizzeria Locale, a Chipotle-backed concept at Arapahoe Marketplace in Greenwood Village, Colorado. We continue to see strong retailer demand for our suburban markets. We expect these favorable demographic trends to continue to benefit PECO's well-located neighborhood centers. We have added slides on these Placer insights I just discussed to our investor presentation. Be sure to check them out. I would also like to reiterate, a silver lining of the pandemic. Less resilient neighbors were pulled from our portfolio. Our neighbor mix emerged stronger post pandemic. Another strength of our strategy that we like to highlight is that we have limited exposure to high-risk retailer categories and are well diversified. Our largest non-grocery neighbor is T.J. Maxx, at 1.4% of ABR. And all other non-grocer neighbors are below 1%. Our combined exposure to distressed retailers, such as Bed Bath & Beyond and Party City is minimal. And these two retailers represent less than 30 basis points of our ABR, less than 1%. In addition to our strong rental growth trends, we continue to focus on our pipeline of ground-up development and repositioning projects. We currently have 17 projects under active construction. Of these, 14 are being developed on land we already own, and three are being developed on adjacent land that we acquired. Our total investment in these projects is estimated to be $55 million, with an average estimated yield on cost between 10% and 12%. Additionally, five projects stabilized during the third quarter, and we delivered over 131,000 square feet of space to our neighbors. This space adds incremental NOI of approximately $1.9 million annually. These projects are attractive because they provide superior risk-adjusted returns and have a meaningful impact on our NOI growth rate. The list of projects in our third quarter supplement represents projects currently in process and does not include the pipeline of projects that we are evaluating. The 16 projects that we expect to complete in 2022 is the largest number we have ever achieved in a year as a company. This is an area where we see ongoing opportunity and we are focused on growing our level of opportunity in these activities in the future. Thank you. I'd now like to turn the call over to John.
John Caulfield, CFO
Thank you, Devin, and good morning and good afternoon everyone. As Jeff indicated, you won't care to say, we are completely immune to all the impacts of an economic downturn. But the good news is that we are operating from a position of strength, with several tailwinds heading into 2023. Our growth opportunities remain attractive, featuring a healthy mix of neighbor demand across our growing markets, strong grocery anchors, necessity-based goods and services, and our right-sized format, with retention rates that continue to be above historical averages. With that, I’ll get into the quarter. Third quarter 2022 Nareit FFO increased 26.4% to $72 million or $0.55 per diluted share. This result benefited from an increase in rental income and reduced interest expense. Our third quarter core FFO increased 15.4% to $76.6 million, driven by increased revenue at our properties from higher occupancy levels and strong leasing spreads, as well as lower interest expense. Our third quarter 2022 same-center NOI increased to $92.5 million, up 4.3% from a year ago. This improvement was primarily driven by higher occupancy and an increase in average base rent per square foot, which was partially offset by lower collectibility reserve reversals in the current period when compared to 2021. Now, I want to provide some commentary on our guidance. As Jeff mentioned, based on the performance we have continued to achieve in 2022, we are raising our Nareit FFO and core FFO per share guidance. Our new core FFO per share guidance range increased to $2.22 to $2.26. We are also increasing our same-center NOI guidance to a range of 4.1% to 4.5%. These increases are a result of strong property results from record occupancy and leasing spreads to date, as well as lower-than-expected corporate and general and administrative expenses. As we look at the fourth quarter of 2022, we anticipate some slowdown as a result of approximately $1.5 million of additional interest expense, primarily due to planned acquisitions as well as seasonally higher expenses. Additionally, we are narrowing our net acquisition guidance range to $200 million to $250 million. This is partly due to timing as certain acquisitions awarded are expected to close in 2023. We also believe there will be even more acquisition opportunities in 2023 as a result of this changing market and we continue to be committed to buying $1 billion of acquisitions net in the first three years post IPO. Despite lower acquisitions than we anticipated this year, our operating performance has allowed us to meet and exceed our expectations for core FFO per share. Turning to the balance sheet. Our leverage ratio continues to be strong as a result of our continued earnings growth as well as our prudent balance sheet management, with our net debt to adjusted EBITDAre of 5.4 times as of September 30, 2022, compared to 5.6 times at December 31, 2021. At September 30, 2022, our debt had a weighted average interest rate of 3.3% and a weighted average maturity of 4.6 years. Approximately 87% of our debt was fixed rate. At the end of the period, we had approximately $733 million of borrowing capacity available on our $800 million credit facility. We have no significant debt maturities until 2024. Between the free cash flow generated by our portfolio and the significant capacity available on our revolver, we have excellent liquidity which is a nice place to be given the current capital markets environment. With the macro market concerns around recession, inflation and rising interest rates, we believe the importance of a fortress balance sheet has increased. Our leverage gives us meaningful capacity and flexibility to pursue accretive acquisitions as they arise in the market and extend our acquisition runway beyond 2024. We still have a target leverage level of low- to mid-six times net debt to EBITDAre. As Jeff and Devin mentioned, we have a strong pipeline of growth with the flexibility to be patient and pursue accretive opportunities that we expect will provide meaningful NOI contribution in 2023 and 2024. And maybe most importantly, as we consider the economic uncertainties, we have one of the strongest balance sheets in the sector allowing us the ability to remain on offense and pivot quickly to create value through acquisitions in response to changing market conditions. With that, we look forward to taking your questions.
Operator, Operator
Your first question comes from Haendel St. Juste with Mizuho.
Ravi Vaidya, Analyst
Hi, good morning. This is Ravi Vaidya on the line for Haendel. Hope you guys are doing well. Just wanted to ask you about the broader transaction market. Where do you – where are cap rates for grocery-anchored centers in your target markets? And where do you think transaction volumes and acquisition cap rates? What's your forecast for 2023 versus 2022, given everything that's happening with the financing and rising rates?
Jeff Edison, CEO
Yes, Ravi, this is Jeff. Thanks for the question. We're focused on rightsized grocery-anchored shopping centers, not power centers or large grocery-anchored centers. We are a leader in acquisitions in this market, which remains one of the most attractive sectors of retail. Pricing has been very aggressive, making it clearly a seller's market for the past 12 to 18 months. However, we are seeing a shift towards a buyer's market, which we expect to continue due to rising debt and increasing equity costs in public markets. While we recognize that market conditions can vary significantly by region and there is a clear expansion of cap rates, we primarily focus on internal rate of return (IRR) rather than cap rates. Currently, we are seeking unlevered IRRs above nine, compared to our target of above eight nine to twelve months ago. This indicates a shift in our underwriting approach based on IRR, which will also impact cap rates.
Ravi Vaidya, Analyst
Got it. Thanks for the color. Just one more here. How has food inflation impacted your grocer tenants? Are you seeing additional sales or foot traffic at your properties given the higher pricing and a broader pullback in casual dining given elevated recession risk?
Jeff Edison, CEO
Devin, do you want to take that one?
Devin Murphy, President
Sure. Thanks, Jeff. Thanks for the question. As foot traffic at our centers is remaining constant so the number of visitors to our centers is equivalent to what it's been last year and this year. What we're finding is that the average spend per visit is higher. And as we mentioned in our prepared remarks, US grocers saw sales increase by over 8% this year, and they're expected to increase again next year. And the good news is that their margins are holding. So we are optimistic that the grocers are going to continue to have a favorable operating environment. They're going to continue to perform well and they're going to continue to drive strong recurring foot traffic to our centers.
Ravi Vaidya, Analyst
Thank you.
Jeff Edison, CEO
Thanks, Ravi.
Operator, Operator
Your next question comes from the line of Juan Sanabria with BMO Capital Markets.
Unidentified Analyst, Analyst
Hi. Good morning. It's Eric on for Juan. I appreciate all the color on the in-line portfolio. I was just curious if you could kind of talk about the health ratio for in-line. You quoted a 10%. I'm just wondering how that's trended coming out of the pandemic? And how should we think about that 10% going forward into 2024 or 2023 and 2024?
Jeff Edison, CEO
Devin, do you want to take that one?
Devin Murphy, President
Sure. Eric, thanks for the question. That metric has remained fairly consistent. We believe there is potential for that metric to increase from the current 10%, depending on usage. Some retailers can manage a significantly higher health ratio than others. On average, we anticipate an incremental growth in that health ratio to around 12%. As long as sales remain stable and continue to grow, we are confident in our ability to raise rents. Our re-leasing spreads this quarter have increased by 15.5%. Notably, our re-leasing spread trend has escalated from about 8% in Q4 2021 to nearly double that at 15.5% now. Alongside this rise in re-leasing spread, we've seen a higher compound annual growth rate, moving from a 2% CAGR in Q4 to almost 3% now. We believe our in-line tenants are performing well and have a health ratio that allows for further rent growth.
Unidentified Analyst, Analyst
Okay. Appreciate that. And then on the in-line portfolio, maybe outside of medical or beauty and hair care, are you seeing any of the less affluent customer step away or any weakness there? I just want to better understand what we're reading in the news and what you're actually seeing on the ground?
Jeff Edison, CEO
It's challenging to get a definitive view on that. I can share that we assess segments primarily based on household income, and we haven't noticed any significant changes. Some of our grocery partners have mentioned that they are observing a trend where some customers are opting for private label brands or trading down to less expensive grocery options. However, this is marginal and not significant at this time. We keep a close eye on this to ensure we can adjust our approach if certain segments start to shift, but as it stands, we are not seeing any substantial changes. If you have anything to add, Devin, please feel free, but that has been our observation thus far.
Devin Murphy, President
Yeah. I mean, Jeff the only thing I would add to that is understand that in our portfolio, the average household income in the three-mile ring is circa $77,000. So this is a middle class customer that is shopping at our centers. So it's not a lower end customer. And I just want to emphasize that point number one. And then number two, the one thing that's underreported from our perspective in the media is the fact that household balance sheets today are in materially better shape than they were pre-pandemic. And the average American consumer has a very strong balance sheet. They have capital that will allow them to continue to spend in a higher inflation environment now that can't go on forever because they will begin to dig into that savings. But the bottom line is employment is at a level where people are continuing to find jobs. As you know one of the big things the Fed is concerned about is how strong the employment dynamic continues to be. So the consumer is employed. They have a strong balance sheet and therefore they're continuing to spend. And we are not seeing any signs in our portfolio of retailers that are beginning to see a negative trend from the consumer.
Unidentified Analyst, Analyst
Appreciate it. Thank you guys.
Jeff Edison, CEO
Yeah. Thanks Eric.
Operator, Operator
Your next question comes from the line of Mike Mueller with JPMorgan.
Mike Mueller, Analyst
Hi, regarding the Crossroads acquisition, can you provide some insight into the initial going-in cap rate and yield? Additionally, it seems you purchased it with approximately 88% or 89% leasing occupancy. Is that still the current leasing rate, or has there been any improvement?
Jeff Edison, CEO
Thanks, Mike, for the question. We have made some progress on that. There is one key second-floor space that is essential for significantly moving the occupancy. The other spaces are smaller, but we have been active and have signed a few leases. While we haven't made substantial progress yet, we are currently ahead of our leasing pace projections. We continue to view Las Vegas as a very strong market with good demand, though we remain cautious. Regarding the acquisition, this was a deal that returned to us. We increased our pricing compared to its previous level. When we evaluated it, we applied a rigorous approach and ultimately secured it at a significantly higher price. Originally, it was under contract in the high fives, and we ended up purchasing it at close to seven, which gives us an unlevered IRR above nine, in our opinion. Thus, it meets our criteria for how we are assessing these centers today.
Mike Mueller, Analyst
All right. Got it. Okay. That's it. Thank you.
Jeff Edison, CEO
Yeah. Thanks Mike.
Operator, Operator
Your next question comes from the line of Ronald Kamdem with Morgan Stanley.
Ronald Kamdem, Analyst
Hi great. A couple of quick ones, just going back to the acquisitions the acquisition market just wondering if you could talk a little bit about sort of what the competition looks like today versus sort of six to 12 months ago, for example, like this recent deal that was closed who was looking at it or were you guys the only ones? Just trying to get a sense who's still out there who's the biggest competitor? Thanks.
Jeff Edison, CEO
There were a number of active leverage buyers in the market, including some who were 1031 buyers, but that segment seems to have diminished. Public companies have pulled back from acquisitions, resulting in a less competitive environment. Some families are still making purchases, but overall competition has significantly decreased. It’s still early to draw firm conclusions, as there hasn’t been much new product entering the market, so much of this is based on limited anecdotal evidence. Generally, we see that competition has reduced, leading to a buyer's market compared to 12 months ago. Devin, do you have anything to add?
Devin Murphy, President
No, I would just say Ron that a year ago there was a depth to the marketplace, and for the types of centers we are looking to acquire, there were five to six buyers very close in pricing. That number has now probably Halved. So now we're down to two to three buyers instead of five to six. There is still demand and the market remains active, but it has less depth than it did a year ago.
Ronald Kamdem, Analyst
Got it. My last question is about the propco deal. You mentioned that you see it as a positive for the portfolio. There were discussions about a possible sale of the portfolio. Do you believe that you wouldn't be affected by that at all, or how do you view it?
Jeff Edison, CEO
With the announcement date, the dividend will not proceed. It's still early to make any definitive statements about what the propco looks like or the nature of the transaction, as there are numerous variables that could affect it, including the possibility of not closing or closing with 300 or 400 stores in propco. We're trying to stay well-informed and be on top of the developments. In general, Kroger and Albertsons are uncertain about the outcome, and the FCC is in the same position. It's premature to make any predictions about where this will lead us. We're committed to staying close to this issue, and our goal is to ensure that each of our grocery stores is operated excellently. We believe that will be the result and we're dedicated to doing everything necessary to achieve that.
Ronald Kamdem, Analyst
Got it. Helpful. Thank you.
Operator, Operator
Your next question comes from the line of Paulina Rojas with Green Street.
Paulina Rojas, Analyst
Good morning. In your prepared remarks, you mentioned that out of period collections were a drag this quarter which is not evident to me from the numbers I can see. So, can you please share with us how much that drag was? And more broadly year-to-date how much 2020 rents have you collected? And is it a reasonable assumption to think of 0 additional collections in 2023?
Jeff Edison, CEO
Paulina, thanks for the call. John do you want to take that?
John Caulfield, CFO
Thank you for the question, Paulina. We did experience some additional out of period collections, but we believe we are returning to normal. Historically, our bad debt has been between 60 to 80 basis points, and in 2022, it's trending closer to 50 basis points. In 2021, we saw even stronger collections compared to 2020. Typically, for the full year, we expect to see negative reserves for collectibility. For the year-to-date in 2022, if we apply the 60 to 80 basis points, it reflects a difference of about $2 million on a year-to-date basis after accounting for reserve reversals. Looking ahead to 2023 and even the fourth quarter, we are seeing amounts below $1 million in payment plans, and our collections from those plans have been quite positive. Therefore, I anticipate that in 2023, we will return to our historical levels of 60 to 80 basis points of revenue.
Paulina Rojas, Analyst
Okay. I'm not sure I follow on the details because there you're talking about bad debt in aggregate right? You're not isolating just prior period collections right?
John Caulfield, CFO
Yes, the challenge is even if I look at just the third quarter I have movement from stuff that was recorded in the second quarter. So that's why I tend to look at it over a longer timeframe. So, I think on the nine months that's where I'm looking at it because when you get down to an individual quarter I have things that I reserved in Q1 reversed in Q3 things reserved in Q2 re-leased in Q3. So, when I say we're back to normal it's kind of those ebbs and flows. And so when I break apart the pieces and say well what did I have in 2022 related to 2021 I would say it's probably about $2 million. And then as I look to 2023 I think if you consider we're back to normal I mean I think in 2023 we will have some reversals from 2022 but at that point it's a normal course. The only thing that's residual from previous years is about $700,000.
Paulina Rojas, Analyst
Thank you for your question. You mentioned that you are interested in the assumptions we use to calculate our internal rate of return. I assume the growth we anticipate is influenced by the specific property details. Additionally, you mentioned growth in cap rates, so I'm curious about what you typically assume for your exit cap rate. If we were to take a longer-term perspective, what do you consider for long-term growth? Do you have standard assumptions for that?
Jeff Edison, CEO
Yes, they are very project-specific. Making generalizations is not how we approach things. We analyze the market where a center is located and assess each space based on the rent we believe we can achieve. We're familiar with many of these markets, which helps us understand rents. We develop specific plans that include rent, tenant improvements, and timelines for leasing or lease renewals. This plan is typically a seven-year outlook considering both operational and financial aspects. Regarding cap rates, as we extend our timeline, the cap rate becomes less significant. However, our guideline is that it will not decrease. In some cases, we may expand it based on the end product expectations after the turnaround, but generally, it starts at a certain cap rate or higher, and we are not reducing cap rates to reach those levels. Operational performance drives this. We regularly review our acquisition underwriting against actual performance. Over the last three years, our properties have outperformed our initial projections, which gives us confidence. We might have been too conservative in our underwriting, but we prefer to err on the side of caution.
Paulina Rojas, Analyst
Thank you. Very helpful.
Jeff Edison, CEO
Yes. Thanks. Thanks Paulina for the questions.
Operator, Operator
Your next question comes from the line of Todd Thomas with KeyBanc Capital Markets.
Todd Thomas, Analyst
Thanks. Just to follow-up on the discussion around investments a little bit. Jeff, I appreciate the detail around that Las Vegas deal. It sounded like a big price adjustment and some of the color you just provided around your targeted IRRs. But just generally, how far are the deals that you're looking at today from sort of penciling out to that 9% unlevered IRR? And then John, can you elaborate a little bit on your comments around that $1 billion of investments that you've talked about over the first three years following the IPO and what to sort of expect in the near term? Just trying to get a handle on the next several quarters really thinking about 2023, just given the changing market conditions and sort of the pullback in the near term that we've seen in terms of investments?
Jeff Edison, CEO
You're thinking about the same uncertainties in the market that we are. We are confident there are strong opportunities ahead, but less certain about the timing. Therefore, we're taking a conservative approach regarding our purchasing plans for next year. One of the key reasons we have worked hard to strengthen our balance sheet and access to capital is to seize opportunities as they arise. We believe there will be opportunities in 2023, and we are well positioned to capitalize on them. We will remain focused on analyzing everything in the market to identify unique opportunities where pricing aligns with the changes in the cost of capital. We are pleased with the deals we closed in the second half of the year and will maintain that discipline moving forward. The market will determine the extent of available opportunities, and we will be very active. However, as you mentioned, it's challenging to predict the market's direction aside from recognizing that the cost of capital has increased, which generally places pressure on the market. We are witnessing fewer buyers and projects returning to us that we haven't seen for 18 months. Thus, we feel optimistic about these emerging opportunities.
Todd Thomas, Analyst
Okay. And then in terms of the same-store results John, the rental income was higher by 6.7%. A very strong result a nice pickup from 5.2% last quarter. I see in the disclosures that's a cash number. It doesn't include reserves or expense recoveries or lease term fee income or anything like that. I think it's just minimum rents, right? What's driving that big increase? Is there anything behind that growth other than leasing and occupancy gains?
John Caulfield, CFO
Thank you, Todd. In the rental income, there are elements like temporary rent and percentage rent. The main factor behind our performance is the re-leasing spreads from our leasing activity. While we have reached peak occupancy, we do not have any collectibility reserves accounted for. There is a page in the supplement that provides additional details on total revenue, which might help clarify the breakdown. We believe this positions us well for continued growth moving forward.
Jeff Edison, CEO
And Todd, this is Jeff. The macro tailwinds that I mentioned in the presentation are genuine and not fabricated to justify our performance. They are occurring in the market and benefiting us. We are now intensely focused on what we refer to as ROS, which stands for rental renewal rates, rent spreads, and occupancy. These three factors explain why we are leading the market in these areas: retailers are choosing to be in our centers at costs they believe will allow them to be profitable. This results in strong renewal rates from those who understand their sales and growth potential. Our occupancy levels are high, with tenants remaining in our spaces, which consistently perform well across the portfolio. Additionally, our rental spreads reinforce this. When you combine these three elements, you have a solid indication of the quality of our assets. They correlate well with our ability to grow the cash flow of the business, which is our primary focus.
Devin Murphy, President
Hey, Todd, it's Devin. You had also asked about the $1 billion. And as you know at the time of the IPO, we committed that we expected to invest acquire $1 billion of assets in the three-year period ended in the second quarter of 2024. So we're basically halfway through that period of time and we've acquired $400 million of assets to date. So we are on track reasonably in terms of hitting that metric. We will continue to be disciplined. And as you know the market is evolving as Jeff has just indicated. But the point that John was making in terms of our capacity is we have the ability today to acquire an incremental $1 billion given our balance sheet flexibility because as you know we're only 5.4 times levered number one. Number two we generate $100 million a year of free cash flow post dividends. And so we have the capital capacity to acquire an incremental $1 billion of assets and stay within our leverage metrics before needing to go back to the equity market. So number one, we're on track to hit the $1 billion guidance that we gave at the time of the IPO and we believe we will do that. The timing is uncertain given the uncertainties in the market. But number two, we've got more than enough balance sheet capacity to hit that metric. So that's the reason why we believe that that metric is one that we will be able to achieve.
Todd Thomas, Analyst
Okay. Yeah. No, that's helpful. I appreciate that follow-up. And then John, back to rental income though for a second. Can you remind us if some of the ground-up and redevelopment taking place within the same-store centers is a potential contribution? Is that positively impacting the same-store as that NOI comes online?
John Caulfield, CFO
It is. That's, right.
Todd Thomas, Analyst
Okay. And what's the contribution from development and redevelopment look like for the full year, within the revised same-store guidance?
John Caulfield, CFO
I believe that the revised growth is around 100 basis points. We are very optimistic about our ongoing projects, and while we haven't disclosed our pipeline, we have development activities underway, supported by positive trends. Our occupancy is at a record high, and we are managing this growth in a controlled manner, which allows us to expand our operations and redeploy capital for strong returns. We are confident that this will sustain our growth moving forward.
Todd Thomas, Analyst
Okay. Great. That's helpful. And just one last one for me. The transaction expenses in the quarter about $3.7 million. What is that attributable to? I guess, why are they being expensed at that level I guess, Crossroads or the Las Vegas deal I know, some of the accounting changes it's back and forth over the years I guess. But I thought the all costs were capitalized. So are these deal-related costs from deals that are not being completed that you're pursuing? And I'm just curious what that is. It seems like a pretty big number.
Jeff Edison, CEO
John, do you want to take that?
John Caulfield, CFO
Sure, I'll take that. Thanks. A part of it is related to the capital we allocate for acquisitions we've completed, which we are able to capitalize. We also had transactions we were pursuing, but due to changes in circumstances, we decided not to proceed with those. Additionally, we have some ongoing expenses each year that we expect to decrease in relation to our IPO, primarily due to amortization.
Todd Thomas, Analyst
Okay. All right. Great. Thank you.
Jeff Edison, CEO
Thanks, Todd.
Operator, Operator
Your next question comes from the line of Tayo Okusanya with Credit Suisse.
Tayo Okusanya, Analyst
Hi, good afternoon, everyone. I noticed that during one of your peers' earnings calls, they emphasized their stronger demographics, which could serve as a key advantage in a slowing economy. I'm interested in your perspective on this, particularly regarding how you expect your portfolio to perform in a tougher economic climate. I understand that your focus is on necessity shopping and that your demographics are more middle-class. However, compared to the affluent segment of the market, how do you anticipate your performance will be in this context?
Jeff Edison, CEO
That's a great question, and we've been discussing this for a long time. We believe our centers cater to the average and slightly above-average American, providing them with essential goods close to home. Our properties serve this customer segment, which is where grocery retailers like Publix, Kroger, and Albertsons generate their revenue, and we align closely with them. It's important to note that this segment is often misperceived as a lower-end market, but our centers do not serve that demographic. The lower-end customer falls into a median household income of $30,000 to $50,000, whereas we focus on those with a median income of $77,000. This represents most of America, where people shop for necessities within three miles of their homes at stores like Kroger or Publix. Current economic conditions have resulted in this customer segment possessing a stronger balance sheet than in previous recessions. Unemployment rates are low, and unlike prior downturns, the biggest difficulties for the middle class have generally stemmed from job losses, which is not an issue today. While the Federal Reserve may be attempting to address economic challenges, significant layoffs are primarily concentrated in the technology sector. When we assess our centers, we believe that the favorable conditions we discussed in our presentation, combined with the stability that necessity-based shopping offers during tougher times, mean our centers deliver stronger performance with less volatility. We feel this is a favorable time to invest, as it helps mitigate risks while also providing potential for growth.
Tayo Okusanya, Analyst
That’s actually very helpful. Thank you.
Jeff Edison, CEO
Yes. Thanks.
Operator, Operator
Your next question comes from the line of Craig Schmidt with Bank of America.
Craig Schmidt, Analyst
Yes. Thank you. I know we've been talking about the Kroger and Albertsons merger. But what happens if the merger between these two doesn't go through? What does that mean? I mean we hear that the merger is trying to help them compete against Walmart and Amazon and that some of the investors in Albertsons are looking at a way to exit stock. What are your thoughts about if the merger doesn't go through?
Jeff Edison, CEO
Thank you for the question, Craig. In my opinion, the service will determine the outcome following the lawsuit if they lose and the merger doesn't proceed. If that occurs, their strategy has been straightforward. They intend to sell and exit their investments. We've heard rumors of other potential buyers being involved in discussions, so they might return to those parties. There's also the possibility of breaking up the company and selling it regionally. Additionally, they could decide to hold onto it long-term, continually releasing shares into the market as a way to exit. This situation remains quite uncertain for us. I believe that selling to a buyer other than Kroger could be one of the best outcomes for us since it would bring another strong competitor into the market that would invest in the stores, which is favorable. If they do break it up and sell it in pieces, it will depend on who acquires what. I believe they have the opportunity to do that, but with today's announcement, we’re likely looking at a lengthy process lasting 18 to 24 months. We’ll gain more clarity as things progress. However, I would emphasize that the most critical decision in this entire scenario will be determining which judge will oversee the case, likely in Washington D.C., where the FTC is challenging the merger. That judge will be a pivotal factor in this situation, more so than the other aspects we are discussing.
Craig Schmidt, Analyst
Great. Thanks for those comments. And then just thinking about the more recessionary resilient portfolio that you have, does this mean that your sales will be flat while other formats may be negative, or do you think PECO can actually see stronger sales and foot traffic in 2023?
Jeff Edison, CEO
We believe that, we can continue to see stable traffic probably increasing cost per basket. So sales going up probably not – we don't see a ton of increased traffic, because I think things will probably, not probably move as much in that direction. So that would be an increasing – that would be increasing sales. We could – we would say that, that's a likely outcome for 2023. Now, if the Fed has to slam the brakes on harder and harder and harder, and we don't seem to be able to handle inflation, it doesn't seem to be. Now that is, a different story. You will – I mean, the customer will change their habits. Our view is the customers most likely to change habits, when employment changes when they don't have the certainty in their job that's when it tends to move even more in our mind than balance sheet. It's like when they – if they've got a job, they will continue to spend maybe at a slightly reduced rate but they'll continue spend. So I would say that, our centers grocery sales will be up in a recession, and they historically have been. Our small stores will be stable in terms of sales. That's our guess.
Craig Schmidt, Analyst
Thank you.
Jeff Edison, CEO
Yeah. Thanks, Craig.
Operator, Operator
This concludes our question-and-answer session. I would like to turn it back to Jeff Edison for some closing comments.
Jeff Edison, CEO
Great. Thank you, operator. Our third quarter results continue to highlight the strength of PECO's focused and differentiated strategy of owning and operating, small format, neighborhood centers anchored by the number one or number two grocer in the market. This drives high recurring foot traffic and neighbor demand, and results in superior financial and operating performance, which we've shown this quarter. Our experienced and cycle-tested team our integrated operating platform and grocer-anchored strategy placed PECO in a strong position, despite – and that is even despite the uncertain macroeconomic environment. Our fortress balance sheet and liquidity will allow us to take advantage of the opportunities as they arise. On behalf of the management team, I'd like to thank our stockholders, associates and importantly, our neighbors for their continued support. I hope you all have a great day and a great weekend. Thanks for being on the call.
Operator, Operator
Thank you for participating. You may now disconnect.