Earnings Call: Q4 2019

Mar 2, 2020

Ladies and gentlemen, hello and thank you all for joining this Essential Properties Realty Trust 4th Quarter 2019 Earnings Call. All lines are in a listen only mode, but instructions on how to ask a question will be shared after today's presentation. To get us started with opening remarks and introductions, I am pleased to yield the floor to Senior Vice President of Capital Markets, Mr. Dan Donlin. Welcome, Dan. Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties' Q4 2019 conference call. Here with me today to discuss our Q4 results are Pete Mavoides, our President and CEO Craig Sievert, our COO and Hillary Hai, our CFO. During this call, we will make certain statements that may be considered forward looking statements under federal securities law. Company's actual future results may differ significantly from the matters discussed in these forward looking statements, and we may not release revisions to these forward looking statements 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 filings with the SEC and in today's earnings release. Before I turn the call over to Pete, we would like to apologize to investors and analysts' inconvenience by the rescheduling of our earnings date and conference call. Unfortunately, with 2019 being our 1st year as a large accelerated filer, the process of getting through SOX compliance and completing our audit required additional time relative to our initial expectations. With that, Pete, please go ahead. You to everyone who's joined us today for your interest in Essential Properties. We are very pleased to report another strong quarter of results. Consistent with past quarters, the 4th quarter saw solid portfolio performance with same store rent growth of 1.7% and no vacancy. Investment activity during the quarter was robust with $205,000,000 invested into 94 properties and 41 separate transactions at a 7.3 quarter on the capital markets front. We closed a $430,000,000 unsecured 7 year term loan, which has a $70,000,000 accordion feature. We also raised $103,000,000 of gross equity proceeds via our ATM program. The end result is that we are reporting 4th quarter AFFO per share of $0.30 representing an 11% year over year growth rate. Looking back at the year, we experienced a transformative improvement in our cost of capital, which allowed us to take a more aggressive stance in regards to our investment activity and balance sheet. We invested $687,000,000 into 3 75 properties in 136 separate transactions at a 7.4 initial cap rate. We raised $424,000,000 of gross equity to maintain a well capitalized balance sheet and raise $630,000,000 of senior unsecured term loan debt to further unencumber our asset base, extend out our maturity schedule and lower our weighted average interest rate. In addition, we sold $519,000,000 of secondary shares from our founding capital partner, which allowed us to increase our free flow and daily trading volume, while further broadening our investor base. Lastly, we increased our quarterly dividend by 9.5% during the year to year, while maintaining a conservative payout ratio in the 70% range. We are proud of these accomplishments, and I would like to thank all of our employees, shareholders and other stakeholders for their support in closing out a very successful 2019. Turning back to the Q4 and starting with our investment activity. We invested $205,000,000 at a weighted average initial cap rate of 7.3%. Approximately 81% of our 4th quarter investments were directly originated sale leasebacks or mortgage loans subject to sale leaseback transactions. 41% contained master lease provisions and 99% are required to provide us with corporate and unit level financing reporting on a regular basis. On the disposition front, in an effort to proactively mitigate risks and exposures, we sold 8 properties in the quarter at a 6.9% cash cap rate, which generated $15,200,000 in net proceeds. Looking at the year end portfolio, we had investments in 1,000 properties that were 100% leased to 2 0 5 tenants operating 16 different industries. Our weighted average lease term stood at a sector leading 14.6 years and just 2.7% of our ABR is expiring prior to 2024. Our same store portfolio represented 62% of our ABR at quarter end, experienced cash rent growth of 1.7%. As we have mentioned in the past, when coupling our contractual rent growth with lease rollovers and potential credit loss, we expect same store cash rent to approximate 1.5% per annum over time. We are pleased to have exceeded this threshold every quarter since coming public, which we believe is a testament to our well diversified, newly underwritten portfolio. From a tenant health perspective, our portfolio has a weighted average rent coverage ratio of 2.9x with 72.6 percent of our ABR having rent coverage ratio of 2 times or better. Looking out over the next 10 years, less than 1.5% of the leases that expire have unit level rent coverage below 1.5x, which we believe indicates a high likelihood of lease renewal at expiration. Additionally, only 1% of our tenants have both an implied credit rating lower than B for Moody's risk calc With that in mind, a key element of our investment strategy is to take calculated tenant risk to achieve what we believe are superior risk adjusted returns. We seek to mitigate these risks through our structuring process, which focuses on direct sale leasebacks on our lease form with master lease provisions and contractual tenant reporting requirements. We further reduce risk by owning granular and fungible real estate properties that are highly liquid in the sales market and readily fungible from a leasing perspective. We believe we are well compensated for these risks. Namely, we have invested at a 7.6 weighted average cash cap rate since inception. The collateral benefits of our attractive initial yields are lower basis in our real estate and the ability to execute de risking sales of individual properties at cap rates that are nearly 100 basis points lower than our initial investment. This runs contrary to paying significantly lower cap rates for properties leased to investment grade tenants, which often results in an inflated basis, inferior lease structures and limited unit level visibility, thereby providing little margin for error in our view. With all that said, subsequent to year end, Art Van Furniture, our 3rd largest tenant at 2.5% of ABR, publicly commented that they are actively exploring a variety of options with creditors, investors and landlords to ensure the company's future. We have remained in constant dialogue with Artvin and their advisors, but it is still too early for us to opine on the eventual outcome. As a reminder, we own 4 properties leased to Art Van, representing roughly 241,000 square feet. We acquired our Ardban exposure in a 5 unit sale leaseback transaction in March of 2017. And after selling 1 property in the Q2 of 2019, our yield on cost is 7.9%. Per our disclosure, Ardvan is currently paying approximately $16 per square foot in rent at our properties, and the range of potential outcomes can be readily calculated when looking at market rent comparable. Keeping that in mind, we are managing an increasingly diverse and granular portfolio of net leased properties. No tenant represents more than 3.4% of ABR and our average ABR per property is approximately $152,000 which is among the lowest in the net lease sector. As such, our portfolio is built to withstand the impact of episodic tenant issues like Art Van and we are reiterating our 2020 AFFO per share guidance of $1.27 to $1.30 As we look out to the balance of the year, we remain focused on growing our portfolio through the origination of sale leaseback transactions with middle market tenants in our targeted industries. And we anticipate our level of investment activity to be consistent with our historical averages with cap rates in the low to mid-seven percent range. And with that, I'd like to turn the call over to Hillary Hai, our CFO, who will take you through the financials for the Q4. Hillary? Thank you, Pete, and good morning, everyone. Starting with the balance sheet, we ended the quarter with $2,100,000,000 of total undepreciated assets and $735,000,000 of total debt. We have no significant debt maturities before 2024, and our net debt to annualized adjusted EBITDAre was 5x@quarterend. However, when adjusting for the impact of our January follow on offering, which raised $192,000,000 in net proceeds, our pro form a quarter end net debt to annualized adjusted EBITDAre was 3.6x. This gives us ample capacity to continue to execute on our external growth strategy, while managing within our targeted leverage range. Moving on to our capital markets activities. During the quarter, we utilized our ATM to sell over 4,000,000 shares of common stock at an average price of $25.23 raising gross proceeds of over $103,000,000 On the debt front, we drew down $250,000,000 on our $430,000,000 7 year unsecured term loan facility, which has an additional $180,000,000 of available borrowing capacity and a $70,000,000 accordion feature. Turning to the income statement. Our 4th quarter NAREIT defined funds from operations, or FFO, was 25,300,000 dollars or $0.31 per diluted share. Core funds from operations or core FFO was 26,200,000 dollars or $0.32 per diluted share and adjusted funds from operations or AFFO was 24,400,000 or $0.30 per diluted share. Of note, in the quarter, we wrote off $887,000 of deferred financing costs, which resulted from the voluntary prepayment of $70,400,000 of Series 20 sixteen-one secondured ABS notes. Turning to the expense front. Our G and A as a percentage of total revenue was 13.5%, which was on par with our trailing 4 quarter average. Going forward, we continue to expect our G and A to grow on an absolute basis, but to decline as a percentage of total revenues. As Pete mentioned, we are reiterating our 2020 AFFO per share guidance range of $1.27 to $1.30 which at the midpoint implies approximately 13% growth year over year. As we have stated in the past, our historical investment activity, which we provide on a trailing 8 quarter basis and our quarterly supplemental is a good goalpost for our future investment potential. With that, I'll turn the call over to COO, Greg Seiber. Thanks, Hillary. During the quarter, we invested $205,000,000 into 41 transactions in 94 properties at a weighted average cash cap rate of 7.3%. These investments were made within 9 of our 16 targeted industries with the car wash, medical, dental and QSR Industries representing over 70% of our investment activity in the quarter. The average lease term of these properties was 16.3 years, the weighted average rent escalation was 1.3% and the weighted average unit level coverage was 3.1 times and our average investment per property was $2,000,000 Consistent with our investment strategy, approximately 81% of our 4th quarter investments were originated through direct sale leasebacks and mortgage loans, subject to a sale leaseback transaction, which are subject to our lease form with ongoing financial reporting requirements. In addition, 78% of our 4th quarter investment activity was relationship based. From an industry perspective, QSRs remain our largest industry at 14.2 percent of AVR followed by car washes at 12.5%, early childhood education and C Stores at roughly 11% each and medical dental at 10.6%. Conversely, our home furnishings concentration is now just 3.5 percent of ABR, which is down 70 basis points quarter over quarter and down 260 basis points year over year. We expect this trend to persist as we see better risk adjusted returns in other industries. From a tenant concentration perspective, no tenant represented more than 3.4% of our AVR at quarter end. Our top 10 tenants represented 23.4 percent of our AVR, which was down 2 10 basis points quarter over quarter. We expect our top 10 concentration to decline further in the coming quarters as we continue to grow our concentrations with existing tenants outside of our top 10. Looking at the portfolio more broadly, approximately 94.4% of our ABR is derived from tenants that operate service oriented and experience based businesses, which is a 680 basis point increase since our IPO. We believe tenants in these industries and more importantly, real estate occupied by these tenants are more recession resistant and better insulated from e commerce pressures. Moving on to asset management, our portfolio remains healthy with a weighted average rent coverage of 2.9 times and 72.6 percent of our ABR having a rent coverage ratio of 2 times or better. In addition, with 98% of our tenants required to report unit level financials to us, we have near real time transparency into the health of our tenancy, which is an important component to managing risk in our portfolio. In terms of dispositions this quarter, we sold 8 properties for 5 different industries for $15,200,000 net of transaction cost. Despite having 1.7 unit level coverage, we achieved a 6.9% weighted average cash cap rate on the 7 leased properties that we sold, which equated to an 8.5% realized gain versus our allocated purchase price. With that, I will turn it back to Pete for his concluding remarks. Thanks, Greg. Our portfolio remains in excellent shape today with healthy coverages coupled with strong transparency, high property level liquidity and de minimis near term lease expirations. Our pipeline is healthy with over $90,000,000 of closed investments through February. With our January equity offering, our balance sheet is extremely well positioned to fund our growth objectives as we look forward to continuing to execute our business plan. Again, I would like to apologize for any inconveniences caused by our earnings call being unexpectedly pushed back. We look forward to meeting with many of you in the next several days at the Citigroup REIT conference. With that, operator, please open the call for questions. Pete, thank you. And thank you to each of our presenters for your remarks today. And to our audience joining today over the phones, if you would like to ask a question at this time, simply press star and We'll hear first from the line of Greg McGinniss at Scotiabank. Please go ahead. Your line is open. Hey, good morning, everyone. Craig, in Q4 actually, let's start with Pete. We appreciate the update on Ardvan. I was just hoping you could clarify what the impact from that tenant is that's embedded in guidance? Listen, we have a range of guidance and we have a range of scenarios around our advanced resolution in guidance. And regardless of those scenarios, the guidance holds. And so it's really too early to speculate on specific impacts, but our guidance holds independent of the resolution of ARDVAN. Okay. So at the very least, we can assume that there is some impact at least embedded into that lower end of guidance? Sure. Yes. Okay. And then Craig, so in Q4, there was a few shifts in top tenant lists. We had Tom Sports rejoin, Our Store Lady Bird falling off. Could you just give us some details as to what drove those changes? Yes. We had one property for the Lady Bird transaction, which was kind of a temporary loan that they paid off. So it was we did a portfolio and there was one short term property we they intended to exit from and they executed on that, so they just dipped down slightly. And then our stores was acquired by GPN during the quarter. Next, we'll take a question from the line of Ki Bin Kim at SunTrust. Please go ahead. Your line is open as well. Thanks. I know you guys addressed us in the morning comments about the change in the date in the earnings release. But I just want to make sure that there's kind of all the details are out there. Was there anything that came out from the delayed earnings release and the 10 ks? No, no. We filed a clean 10 ks this morning and it was purely just getting through that process as a 1st year stocks compliance. Okay. And obviously, I don't want you to negotiate against yourself on a conference call, but what do you think, are some of the likely scenarios come out of our fan? Yes. And listen, I'm purely addressing hypothetical scenarios here, but it could be a liquidation. It could be someone buying a portion of that company and assuming our lease with the lease amendment or it could be a Chapter 11 restructuring. And it's really all three of those scenarios are currently in play as we continue to have dialogue with that company. Could you talk about the real estate quality for the couple boxes that you have? Yes. We own 4 furniture stores in Michigan. There are Advanced Furniture stores and we have a couple of very good ones and a couple of average ones. They're all subject to a master lease. As I said in the prepared remarks, 214,000 square feet with about $16 a square foot in rent. And if I could squeeze a last question in here. I guess more importantly though, is there any lessons learned from the ArtFan scenario? Every time you go through one of these, you learn some lessons. I think we saw the declining performance in our van coming. We tried to sell the properties that they had been listed for a long period of time. And one of the key lessons and we often talk about our granularity and our liquidity and given the size of these assets, they were a little less liquid than our average assets. And so that's a lesson we continue to reinforce in our investment process. Okay. Thank you. You got it, Ki Bin. Thanks. Our next question will come from Douglas Harter at Credit Suisse. Hi. This is actually Sam Cho on for Doug today. So I'm seeing that the experience sectors kind of consist of 14% of your portfolio. And I'm just kind of thinking through more of the macro picture. If there is some sort of impact with the pandemic, I'm just curious as to how you guys see the tenant credit trending, if you have any commentary on that? Yes, I would say clearly and if you think about our entertainment sector comprising bowling alleys and movie theaters and places where people congregate, if the pandemic spreads and people elect not to use those facilities, it's going to impact the profitability of our tenants. And the magnitude of that really depends upon the depth and the breadth of that change in customer behavior. We believe it would be temporary and certainly as a landlord with healthy coverage and master leases and healthy tenants, we would expect our tenants to be able to kind of withstand that temporary dislocation, but it's certainly something we're going to watch very closely in the coming quarters as we get unit level of profit and loss statements that come in and monitor our tenant health, which is an important part of our credit discipline. Now do you have the average tenant credit for these sectors versus other segments in your portfolio? We do. That's not something we necessarily disclose. I would say that generically, the coverage and the credit profile of our entertainment tenants is very similar to our overall portfolio. Okay. That's helpful. Thank you. Thank you, Douglas. Our next question will come from Nate Crossett at Berenberg. Hey, good morning, guys. Appreciate the color on our event. Are there any other tenants on the watch list that we should be aware of? No. Nothing material. Clearly, American Blue Ribbon has been a name that people have been talking about. We have 7 properties with them, but we don't expect to experience any kind of rent loss through that process. But overall, the portfolio is in great health, really attributed to being recently underwritten with fresh diligence and we feel good about where we're sitting. Okay. And what about just like home furnishing in general? I know this is kind of an RVAN specific issue, but it looks like there's maybe 3 other locations, not RVANs that you have that are home furnishings. Maybe what are those and how do you feel about them? Yes. Listen, I think our home furnishing exposure has been coming down quarter over quarter since really since 2017 as we haven't been investing in that sector. We don't love the sector and really think there's a surplus of big box retail spaces in our country that provides competition for our real estate. And so we have very modest furnishing exposure and modest and decreasing. And clearly, the 3 sites we have, we're comfortable with. Some good sites and one's in Dallas, Plano Metro, which is a real strong submarket and others in Fort Worth, which we feel really good about. And the third one is more of an upscale site outside of Kansas City. So the exposure we have, we feel good about. It's very modest, but overall, it's an industry that we have not been adding to. Okay, thanks. Our next question will come from the line of Brian Hawthorne at RBC Capital Markets. Hi. Your exposure to tenants with credit ratings of CCC plus and B increased this quarter. What drove that change? That was largely driven by ArtVant and their year end financials coming in weaker and getting a credit downgrade per the model. That's it? There's another there's about another 100 basis points in there and they're all just kind of small operators. Okay. And then can you provide an update on the performance of the Perkins assets you have? We really just kind of restructured that in the Q4 and I haven't really got through their kind of year end numbers yet. But we would imagine the sales at the sites we had were stable going into the restructuring and one of the reasons why our lease was extended and affirmed and I wouldn't anticipate any issues there. But the recapitalized tenant with a firm lease is not something that gives us a lot of concern, but certainly something we're watching. Okay. Thank you for taking my questions. You got it, Brian. Thank you. Next, we'll hear from the line of John Massocca at Ladenburg Thalmann. Go ahead. Your line is open. Good morning. Good morning, John. So, what types of car washes were kind of in the acquisition activity in 4Q, just because the 2 tenants you have in the top 10 didn't seem to increase at all? Greg, why don't you give some color there for him? Sure. I mean, we're adding on the car wash side, we have a lot of regional operators that perhaps have the dominant market share in their market in a lot of parts of the country. So we have a few groups in that kind of 10 to 35 store dominant local player kind of operator that we've been able to do a lot of direct sale leasebacks with. So that's kind of the profile. Yes. And just to add some color there, John, you look at these big national guys when they get to a couple of 100 units, so they get pretty efficient in the sale leaseback market and start charging cap rates in the low 6s. And we prefer to go with the regional kind of 10 to 50 unit guy and get that extra 100 basis points and just add a little more value there. And so that's kind of part of our investment methodology. Total exposure? Say again? You broke up on us. Sorry. Just broadly speaking, how kind of big are these operators in terms of the total number of units they are operating? As Greg said, it could be a 10 to a 50 unit operator. Okay. And then Sorry, I had a little trouble with headset. Sorry, guys, I am having a little trouble with my headset. Can you hear me? Yes, we can. Okay. And then last question, does the current macro backdrop and the volatility in the capital markets change how you guys view leverage and maybe the pace of capital deployment? Sure. I mean, listen, we see what's going on with the pro form a year end leverage sub-four, we feel pretty comfortable. And as we deploy this capital and we look out and we continue to invest, we will certainly be cognizant of the volatility and our own individual cost of capital. And certainly, we feel like our balance sheet is positioned to weather a storm and we just need to be cognizant about how long that storm may last. Okay. That's it for me. Thank you guys very much. Thanks Sean. We'll take a follow-up from Ki Bin Kim at SunTrust. Thanks. So excluding this past week, you guys were trading at a pretty healthy valuation level, at 1 point sub 5 percent implied cap rate. Obviously, that gives you the ability to raise some efficient debt and equity. But it also gives you a little more leeway in terms of maybe not having to buy a mid-seven cap rate. Maybe it gives you the ability to increase the quality of acquisitions. Has that translated all into the type of assets you're targeting for investments? Yes, listen, we buy what we believe to be the best risk adjusted assets that we can source through our relationships and sell leasebacks transactions and get the most attractive cap rates. And we reject the notion that investment quality is solely equated to cap rates. Clearly, our cap rates have come down. From a year ago, we're transacting in the mid to high 6s, now we're excuse me, mid to high 7s and now we're transacting in the low to mid 7s. But our investment discipline and the way we view risk is really an output of our collective 50 years of investing in this space, not the output of our cost of capital. And so what we buy is really the best stuff we can find with the most attractive yields. Okay. And a question for Greg. I know it's early, but is there any discernible trends you're seeing from the investment landscape for assets that are out for sale, maybe in particular that relates to experiential or restaurants, any kind of hesitancy or change in cap rates at all? I mean, not yet. I mean, we don't we have, as you probably know, a few a number of assets on the market. We have people under or buyers under some purchase contracts to purchase those. And I mean, we haven't seen anyone fall out or try to re trade because of what's going on in the stock market. Okay. Thank you. And at this time, we have no further signals from our listening audience. I'll turn it back to our leadership team for any additional or closing remarks. Great. Thanks, Jim. Thank you all for participating today. Thank you for the questions. Again, we apologize for the inconvenience and we look forward to talking to you all in the future. Thanks again. Bye now. Ladies and gentlemen, this does conclude today's update and we do thank you all