Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust third quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. This conference is being recorded and a replay of the call will be available two hours after the completion of the call for the next two weeks. The dial-in numbers for the replay can be found on today's press release. Additionally, there will be an audio webcast available on Essential Properties website at www.essentialproperties.com. An archive of which will be available for 90 days. It is now my pleasure to turn the call over to Dan Donlan, Senior Vice President and Head of Capital Markets at Essential Properties.
Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties third quarter 2021 conference call. Here with me to discuss our operating results are Pete Mavoides, our President and CEO, Gregg Seibert, our COO, and Mark Patten, our CFO. During this conference call, we make certain statements that may be considered forward-looking statements under Federal Securities law. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements, and we may not release revisions to those forward-looking statements to reflect changes after the statements were made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the company's files with the SEC and in yesterday's earnings release. With that, Pete, please go ahead.
Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. The third quarter was another strong quarter for us on all fronts as we saw a continuation of the trends that have been present throughout the year, including strong portfolio performance, a robust and attractive investment environment, and supportive capital markets. In terms of the portfolio, with collections at 100% and only one vacant property today, our portfolio has fully stabilized. In fact, over the trailing 12 months ended September 30, we experienced recovery of 87% on all re-leasing activity, which is a strong indicator of the quality of our real estate and our disciplined underwriting. Two, in terms of investments, similar to past quarters, our industry relationships drove the bulk of our growth as over 80% of our investments in the quarter were prior relationships.
During the quarter, we invested $231 million into 85 properties at a weighted average cash yield of 7%, with 84% of investments originated through direct sale-leasebacks and 80% containing master lease provisions. While we expect this high level of investment activity relative to our historical averages to persist into the fourth quarter, our future investment activity levels are likely to moderate for three main reasons. One, activity paused during the pandemic demand has largely been recaptured. Two, product from sellers motivated by potential changes in the tax laws should dissipate next year. Three, pandemic-induced M&A activity moderates back to more normalized levels. Lastly, in terms of the capital markets, we remain active on the equity issuance front with approximately $103 million of gross ATM issuance during the quarter, which helped lower our leverage sequentially.
As such, we continue to have ample capacity to capitalize on our investment pipeline. Turning to the portfolio more specifically. We ended the quarter with investments in 1,397 properties that were 99.9% leased to 297 tenants operating in 17 industries. Our weighted average lease term stood at 13.9 years, with 3.8% of our ABR expiring through 2025. Our weighted average unit level coverage ratio was 3.5x , which improved versus last quarter's coverage of 3.2x .
While our traditional credit statistics, which focus on implied credit ratings and unit level coverage, experienced solid sequential improvement this quarter, these statistics remain negatively skewed for certain industries like movie theaters, early childhood education, and health and fitness, which face continued state level shutdowns and capacity restrictions well into the spring of 2021 in certain areas of the country. However, with most of our tenants reporting to us on a trailing twelve-month financial basis with a one-quarter lag, we expect these statistics to continue to experience solid sequential improvement over the next few quarters. Looking out to the balance of the year, we expect these positive trends to continue, and we are reaffirming our 2021 AFFO per share guidance range of $1.30-$1.32.
In addition, we are establishing our 2022 AFFO per share guidance at a range of $1.46-$1.50 per share. We continue to believe our strong AFFO growth potential, combined with our well-covered dividend and our commitment to prudently manage our balance sheet and portfolio risks, offers investors a compelling total return opportunity. With that, I'd like to turn the call over to Gregg, our COO, who will take you through the portfolio and investment activity in greater detail.
Thanks, Pete. During the third quarter, we invested $231 million through 31 separate transactions at a weighted average cash yield of 7%. These investments were made in 12 different industries, with 70% of our activity coming from Grocery, Auto Service, Equipment Rental and Sales, Early Childhood Education, and Casual Dining. The weighted average lease term of our investments this quarter was 16.4 years. The weighted average annual rent escalation was 1.6%. The weighted average unit level coverage was 2.8x , with the average investment per property being $2.7 million. Consistent with our investment strategy, 84% of our quarterly investments were originated through direct sale-leasebacks, which are subject to our lease form with ongoing financial reporting requirements, and 80% contain master lease provisions.
Looking forward, we are seeing increased competition from existing and new market participants due to the growing appreciation for the durability of the asset class. As a result, we continue to see cap rate compression as we seek to service and protect our relationships. From an industry perspective, early childhood education is our largest industry at 14.5% of ABR, closely followed by Quick Service at 13.2%, Car Washes at 12.9%, and Medical/Dental at 11.7%. We continue to view these four business segments as Tier 1 industries for Essential Properties, and therefore, they are likely to remain our highest concentration industries for the foreseeable future. Of note, we continue to selectively invest in proven operators of profitable locations in both the entertainment and casual dining industries, which continue to experience strong rebounds in revenues and profits.
From a tenant concentration perspective, no tenant represented more than 2.7% of our ABR at quarter end, and our top 10 tenants account for just 19% of ABR, which was down 50 basis points versus last quarter. Increased tenant diversity is an important risk mitigation tool and differentiator for us, and it is a direct benefit of our focus on large, unrated credits and middle-market businesses, which offers a significantly more expansive opportunity set than a strategy concentrated on publicly traded companies and investment-rated credits. In terms of dispositions, we sold 11 properties this quarter for $10.1 million in net proceeds. When excluding transactions cost and properties sold subject to tenant buyback options, we achieved a 6.5% average cash yield on these dispositions.
As we have mentioned in the past, owning liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants, and unit-level risk within the portfolio. With that, I'd like to turn the call over to Mark Patten, our CFO, who will take you through the financials and balance sheet for the third quarter.
Thanks, Gregg, and good morning, everyone. As Pete noted, the third quarter was another strong quarter for us. The notable elements of our reported operating results for the third quarter of 2021 are as follows: Our total revenue was up $16.7 million or almost 40% versus same period in 2020, totaling $59.6 million for Q3 2021, which reflects the benefits of a full quarter of our $223 million of investments in Q2 2021, and more broadly, our net investment activity so far this year, which has totaled nearly $600 million.
Total G&A was just under $5.6 million in Q3 2021 versus $5.9 million for the same period in 2020, a decrease of 5.4%, which was largely due to a decrease in non-cash stock compensation expense. More importantly, our G&A continues to scale as our cash basis G&A as a percentage of total revenue was just 7.5% for Q3 2021 versus 10.6% for Q3 2020. Net income was $27.6 million in the quarter. Our FFO totaled $43.6 million for the quarter or $0.36 per fully diluted share, a 38% increase over the same period in 2020.
Our nominal AFFO totaled $40.2 million for the quarter, up $13.9 million over the same period in 2020, which on a fully diluted per share basis was $0.33. That's an increase of a bit more than 22% versus Q3 2020. Turning to our balance sheet, the elements I would like to highlight include the following. With another great quarter of investments by our team, our income-producing gross assets reached $3.1 million at the quarter end. From an equity perspective, our ATM program generated approximately $101 million of net proceeds during the third quarter. As Pete noted, our balance sheet remains strong with net debt to annualized adjusted EBITDAre at 4.5x at quarter end and total liquidity of $428 million.
As a result, our balance sheet and liquidity position continue to provide a strong foundation to support our investment pipeline and our future growth goals. Lastly, I'll reiterate Pete's important note that our current investment pipeline, our portfolio outlook, and our strong performance this quarter provided us with a basis to reaffirm our 2021 AFFO per share guidance and establish our 2022 AFFO per share guidance at a range of $1.46-$1.50, which implies a 13% year-over-year growth on a midpoint to midpoint basis. With that, I'll turn the call back over to Pete.
Thanks, Mark. We are encouraged that the operating environment and capital markets have allowed us to capitalize on our robust pipeline of accretive investment opportunities, which are the predominant driver of our earnings growth. More importantly, we believe our disciplined and differentiated investment strategy has created an incredibly resilient net lease portfolio that should continue to generate attractive risk-adjusted returns as we grow into the future. With that, operator, let's please open the call for questions.
Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Our first question comes from the line of Greg McGinniss with Scotiabank. Please proceed with your question.
Hey, good morning. Pete, thank you for the color you provided on the acquisition pipeline in your opening remarks. I appreciate that you're hesitant to provide strict acquisition guidance. When you speak about the pace of acquisitions maybe moderating, should we take that to mean, you know, pre-pandemic level that is reasonable going forward, so $160 million-$200 million per quarter? Or do you anticipate even greater headwinds in 2022?
No, listen, I think, you know, when we came public in 2018, we thought we had an organizational infrastructure to kind of support, you know, $500 million or $125 million a quarter. You know, that has grown, you know, since that time. You know, I think, you know, when we think of moderating, it's more closer to the, you know, eight-quarter average, you know, looking backwards. You know, kind of, I think you're in the right range there.
Okay, thank you. If I'm not mistaken, I believe the unit level rent coverage this quarter at 3.5x is the best you've ever had in the portfolio. Could you help me understand the drivers, the improvement over the historical levels? Obviously, you know, ignoring the pandemic. And then also, which categories generally have higher or lower coverage, especially with the top four categories that you mentioned.
Yeah, listen, I think, you know, that number is a headline number and I think, you know, not a true indicator of what's going on in the portfolio, which is why we try to provide, you know, additional disclosure around that, you know, in our supplement. It's a great number. We're happy about it. You know, certainly, you know, some of the industries that are gonna have higher coverage are gonna be things like the equipment rental, things like medical/d ental, and other services. You know, things that are gonna have lower coverage are gonna be the industries where, you know, the business is solely revolved around the real estate.
You know, clearly the movie theaters in the current environment, quick serve restaurants should be, you know, kind of in that two, 2+ range. There's a wide dispersion of coverage. We certainly think that headline number is healthy.
Great. Thank you.
Thank you, Greg.
Thank you. Our next question comes from the line of Sheila McGrath with Evercore. Please proceed with your question.
Hi. Yes, good morning. I was wondering, Pete, if you could give us a little bit more detail on the G&A outlook in 2022, what was in your guidance, and do you expect that you're gonna have to add more acquisition personnel or just personnel in general?
Yeah, I'll start and then kick it to Mark. You know, obviously we don't guide to G&A. You know, Mark can give you some color, you know, on the trend there. You know, we're staffed, Sheila. We're transacting at a very high level, and I think the team is operating, you know, really in great form. You know, so we don't see a lot of additions in G&A. I think you know, the team and the hiring is in a good spot as it sits now. Mark, you know, from a trend perspective, what should they expect?
Yeah, Sheila, thanks for that question. You know, first of all, just mention that, you know, sort of the puts and takes in 2021 that gave us some good efficiencies was paying off the ABS was not just a benefit to being 100% unencumbered, 100% unsecured, but it allowed us to kind of get more efficiencies in some of our outsourced expenses. We also kind of benefited from, you know, the world around our controllable expenses that has to do with sort of conferences and the like still were generally virtual. Our travel just generally was moderated. We got some benefits from that in 2021.
You know, the way I kind of think about it, 'cause stock comp is sometimes a variable that you can't, you know, peg, but on a cash basis, as a percentage of revenue, if you ran out Q4 2021 at kind of a similar level of where we've been and used that as your kind of percentage of revenue, I think that's a good metric for 2022, maybe with just a little bit of inflation.
Okay, great. The same-store NOI profile, it was significant for retail and experience. I was just wondering if you could provide some detail what was driving those changes.
Yeah. Listen, I think if you think back to a year ago, we had some significant repositionings in the portfolio where sites were taken offline and relet to new tenants. I think, you know, that's the noise you're seeing in the same-store sales number, Sheila.
Okay, one last one. EquipmentShare is now your biggest tenant. I was just wondering if you could provide us a little detail on about that business, that company.
Yeah. They're a growing equipment rental firm with a very differentiated technology platform. We've been doing business with them for a number of years now and have seen them, you know, execute on their growth plan very reliably and efficiently and predictably. We were, you know, happy to continue to partner with them as they continue to kind of grow. I think they're well over 100 units at this point in time, 100 site locations and have a national footprint. More specifically, you know, we generally like the real estate underlying the equipment rental space. You know, large yards with good buildings and industrial zonings tend to have great fungibility and appeal to multiple users. Great company.
We're happy to continue to do business with them, and really solid underlying real estate fundamentals. I would say at 2.7% of ABR, there's room to grow there. You know, we certainly ideally wouldn't have a tenant over 5%. But you know, we feel comfortable where they're at.
Okay, great. Thank you.
Thank you, Sheila.
Thanks, Sheila.
Thank you. Our next question comes from the line of Nate Crossett with Berenberg. Please proceed with your question.
Hey, good morning, guys. Just a question on pricing. I mean, you noted increased competition, you know, but if you look historically, you guys have kind of been able to stay above that 7% mark. You know, I know you don't give specific guidance on this measure, but what are you kind of expecting, I guess, going into next year? You know, is that 7% gonna hold, or how should we be thinking about that, I guess?
Yeah. You know, listen, I think, you know, we're facing increased competition. We fight for every basis point we get. We specifically focus on an investment strategy that allows us to compete on the strength of our relationships and our reliability as a capital provider in order to get, you know, appropriate risk-adjusted returns. The cap rate is, you know, really the blend of the 30 transactions that we did in the quarter across 16 industries and, you know, that can vary greatly from a low of six to a high of an eight, or 7.5. You know, if you look back, you know, it's been 7.1, 7.1, seven. You know, could it dip to 6.9 or, you know, thereabouts? Certainly.
It really just depends upon the opportunity set that we get in any given quarter.
Yeah. That's helpful. Just a question on, I guess, the other side of the equation. You know, saw one of your peers did their first preferred offering this quarter. Just curious to get your thoughts on that type of funding source and how you view it, and if you have priced out anything in that market.
You know, we haven't priced out preferred. You know, we think we have a pretty simple and efficient capital structure today. Certainly, you know, getting our inaugural ABS bonds or our inaugural unsecured bonds done earlier this year and paying off the secured bonds that we had in the ABS went a long way to cleaning up that capital structure. You know, I think we have a little ways to go with the rating agencies before the preferred market is truly efficient for us. But it's certainly a market that we'll keep our finger on the pulse and evaluate over time.
Okay. That's it for me. Thank you.
Thank you.
Thanks, Nate.
Thank you. Our next question comes from the line of Haendel St. Juste with Mizuho. Please proceed with your question.
Hey, good morning. Thanks for taking my questions. I guess first one, I just wanna follow up on the competition you noted. I'm curious, any particular subsectors, asset type, deal size, you're seeing that most prominent in? I think most folks would have thought you're focusing on smaller deals that provide you some insulation. Curious on, you know, what level of competition you're seeing and what impact it's having on pricing and where. Thanks.
Yeah. Listen, I think the competition is most acute for larger deals and larger credits. You know, I think you know bigger credits with bigger deals get more people excited and they're better able to move the needle and you know it gets more competition. You know, with us, you know, transacting $230 million in the quarter in 31 separate transactions, you know, that's, we believe a differentiator for us. Our ability to do small deals and deliver capital through a sale-leaseback reliably allows us to compete and get outsized risk-adjusted returns. You know, the bigger the deal and the bigger the credit, the more competition I think you're gonna see.
Appreciate that. Second question is on, I guess, a follow-up on the 2022 guidance. I'm curious, you know, what's embedded in there from a, maybe a recovery, perspective for sectors that haven't quite recovered to pre-COVID levels, like say, child care, early childhood centers, and any other sectors that, you're still inching back towards pre-COVID levels and any other, deferral income or, recoveries baked in there? Thanks.
Yeah, listen, you know, as we said in the prepared remarks, you know, we think the portfolio's recovered and we're collecting 100 cents on the dollar. While there is some recovery to go yet with the movie theaters and the childcare operators and some of the gym operators, those guys are paying us their current and we expect that to continue into 2022. You know, we bake in a normalized credit loss assumption into our model, which is baked upon very specific views of individual situations. I would say that's more tenant specific and more normalized and not a recovery of COVID sort of analysis.
In terms of our deferrals, you know, essentially the vast majority of our deferrals are behind us, from a recognition perspective. We're probably halfway through the collection of those deferrals. You know, we've been collecting substantially all of that's been due to us.
One clarification if I could. Normalized credit loss, is that definition or the level of reserve any different versus say last year? Well, maybe pre-COVID. Any change in the level of reserve you're taking there? Thanks.
No, I think that normalized is, you know, based upon, you know, historical experience in this asset class. You know, what we're seeing in 2022 would've been very similar to what we were seeing or expecting, you know, prior to COVID.
Thank you.
To put some color around that Haendel, you know, as we've said, you know, any number of times, you know, we build in, you know, roughly 1.6x growth into our lease. The actual growth that we realize over time is offset by a credit loss of somewhere between 25 and 40 basis points.
Appreciate that.
Thank you. Our next question comes from the line of Caitlin Burrows with Goldman Sachs. Please proceed with your question.
Hi, good morning. Looks like leverage was 4.5x as of 3Q, which seems somewhat low. I was wondering if you could go through your view on expected leverage going forward, and to what extent you'd be comfortable having it increase.
Yeah. Listen, our leverage has largely been an output of our desire to de-risk our external growth and keep the dry powder on the balance sheet to you know ensure that we have the ability to execute reliably on our growth plan. You know, it has varied somewhere between four and a little over five since coming public. You know, you shouldn't expect that to change materially going forward. You know, kind of sitting right in that middle of the range you know kind of feels appropriate now. But we certainly don't think about it as a spot estimate given the pace at which we're deploying capital and the sometimes chunkiness in which we raise capital, it's gonna vary. But generally within that range.
Got it. Okay. Could you also go through maybe some more of the thought process of completing dispositions in the quarter? Obviously you have a variety of ways to raise capital, but what made you go that route for those properties?
Yeah. You know, listen, and as we've said, the disposition activity is really largely driven from a risk management perspective, not a generation of capital perspective. The $10 million in assets we sold during the quarter were really getting at assets that we didn't feel met our long-term investment criteria. We're better, you know, moving those out of the portfolio and freeing up that capital to invest into other assets. That's generally our view on selling assets.
Got it. Thanks.
Thank you. Our next question comes from the line of Katy McConnell with Citi. Please proceed with your question.
Thanks. Good morning, everyone. Just going back to the strong growth you saw in same-store rent for experiential tenants in 3Q, can you touch on the key drivers of that improvement? With that, any update on how your theater tenants have been performing?
Yeah. Listen, I would say on, in terms of theaters, you know, the vast majority of our theaters are the five of six of our theaters, to be specific, is AMC. You know, I think everyone, AMC is a public company with very clear disclosure. I think, you know, people can get a good sense of what's going on there. As we said during the pandemic, we think we have good theaters that, you know, work for the tenant. You know, certainly I think coming out, we're seeing that in the numbers. In terms of the improvement in the experiential tenant or the experiential sector, you know, as I told Sheila, that was specifically related to some asset level repositioning.
If you think back a year ago when we worked through our Town Sports bankruptcy, you know, those sites would've been offline for a period of time in the reported period that would've highly impacted that number.
Got it. Okay. For your service-based tenants, I'm curious how much of an impact labor shortages are having there. Are there any categories in particular that you're more concerned about within your portfolio today?
You know, we're not gonna see that. You know, we're getting the financials to us on a trailing 12 basis. Anecdotally, we're hearing that. You know, I just point to the fact that coverage is up across the board and generally everyone's doing well and certainly everyone's paying. It's only anecdotal at this point. You know, we're hearing about labor challenges in the restaurant space and the early childhood education space, but we're not seeing it impact our collections at this point in time.
Got it. Okay. Thank you.
Thank you.
Thank you. As a reminder, ladies and gentlemen, if you would like to ask a question, please press star one on your telephone keypad. Our next question comes from the line of Ki Bin Kim with Truist. Please proceed with your question.
Thanks. Good morning. Just to follow up on that previous question, when you talk to your tenants and, what is your kind of real-time sense of what is happening to their kind of overall profit scenario given that, you know, they're probably getting good top-line growth but facing higher cost structures?
Yeah. You know, I think you kind of see that in the numbers and the coverage, right? Our rents aren't growing that fast, but our coverages are improving. You know, as we said, it's anecdotal, and we haven't really dissected the numbers on, you know, for that. You know, generally I think the recovery that we're seeing and the pickups in and benefit from, you know, recovering from the pandemic is outweighing the headline pressure to margins that, you know, labor and other things would create. You know, all that said, I, you know, that's not a static analysis. I think as we think out, there's gonna be continued pressure to margins and continued, you know, both to cost of goods sold as well as labor.
You know, we'll watch that closely. You know, with coverage at 3.5x and real estate and rent, you know, one of the first line items to be paid, you know, that's more of an operator risk than a landlord risk.
Got it. I guess thus far, have you seen that impact to willingness for some of your tenants to open new stores?
Yeah. You know, listen, the vast majority of our, you know, incremental investment activity is with tenants, you know, opening, buying or merging into new stores. As we've said, it's a heightened level activity and there's a lot of capital feeding that. You know, we have not seen any reluctance for our tenants to continue to grow.
Just last quick one here. Talking about the same thing, the cap rate compression environment and competition. On the flip side, I mean, you could buy, it's probably a good time to sell additional assets that might not meet your criteria. As we look forward, is it reasonable to expect a higher level of disposition activity than what we've seen?
You know, listen, I think generally we've tried to transact, you know, somewhere around 10% of what we've bought, and that's, you know, somewhere between $10 million-$20 million a quarter. You know, certainly, you know, where we're trading, you know, that becomes diluted for us, and so, you know, we're really gonna sell to mitigate risks. I would say, you know, if anything, disposition activity is gonna moderate in the coming quarters.
Okay. Thank you.
Thank you, Ki Bin.
Thank you. Our next question comes from the line of Joshua Dennerlein with Bank of America. Please proceed with your question.
Yeah. Hey, good morning, everyone. Curious on your comments on the potential tax law changes driving M&A activity. Was there any specific area within, you know, where you would look, where you're seeing like a lot of extra activity where it might slow into 2022? Or just kind of curious, if there's any more color you guys could provide there.
Yeah. I think it's a couple things. It's you know, there's the threat of repeal of 1031 exchange that leads you know, people with investment properties you know, more inclined to sell. I would say that's less of an impact. The bigger impact is you know, potential increase in capital gains and you know, taxes on wealthy people motivating people to sell you know, businesses and business investments. If you're a four-unit childcare operator on the cusp of retirement and you know, you're gonna sell your business in the next three to five years you know, the threat of tax change you know, will really accelerate that. Really overall, that would result in the heightened M&A activity that we're seeing.
Interesting. Would any of these potential tax law changes or maybe specifically the 1031s going away impact cap rates at all?
I don't think so. You know, the business seller you know the business seller scenario, that's you know not really a cap rate play. That's more of a business valuation play, and that's you know driven by the overall macro capital markets environment. So I think you know there's not gonna be a direct impact to cap rates there. As we've said in the past you know when we invest in sale-leasebacks you know it's generally not a 1031 motivated scenario. It's you know helping to capitalize a business and we're not competing on cap rates. When we sell we'll sell into the 1031 market but that's you know not a driver.
You know, to be clear, this is just the threat of changes in tax laws, so that, you know, it's not as actionable as, you know, when it becomes apparent that something's gonna change.
Got it. Appreciate the color.
Thank you.
Thank you. There are no further questions at this time. I'd like to turn the floor over to Pete for closing comments.
Great. Well, thank you all for your attendance today, and thank you for your questions. We look forward to engaging with everyone in the upcoming Nareit meetings. Have a great day. Thank you.
This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.