Welcome to Essential Properties Realty Trust third quarter 2018 quarterly financial results. At this time, all participants are on a listen-only mode. A 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. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Dan Donlan . You may begin.
Thank you, operator, good afternoon, everyone. We appreciate you joining us today for Essential Properties' third quarter conference call. Here with me today to discuss our third quarter results are Pete Mavoides, our President and CEO, Gregg Seibert, our COO, and Hillary Hai, our CFO. Before I turn the call over to Pete, I'd like to say that during this conference call, we will make certain statements that may be considered forward-looking statements under the federal securities laws. 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 filings with the SEC and today's earnings press release.
I would like to now turn the call over to Pete. Pete, please go ahead.
Thank you, Dan, thank you to everyone that has joined us today for your interest in Essential Properties. We are thrilled to report our first full quarter as a public company, which we hope will provide a clearer picture of our financial performance and growth potential, highlight the underlying health and transparency of our newer vintage portfolio of single-tenant assets, and outline the results and benefits of our differentiated and focused investment model. As of September 30, our granular portfolio of 645 single-tenant properties was 99% leased, with one fully vacant property that was sold subsequent to quarter end. Our properties are leased to 153 tenants operating in our 15 targeted industries, with approximately 91% of our annual base rent or cash ABR coming from tenants that operate in service-oriented and experience-based businesses.
We continue to focus on operators within these industries as our tenants' customers must visit our properties to either receive a service or have an experience or both. We believe this operator-customer relationship results in predictable behavior and transparent profitability that supports the underlying rents our tenants pay to occupy our properties. As of September 30, our weighted average lease term was 14.3 years, which is one of the longest lease duration portfolios in the net lease space. We believe this should limit erosion in our rents or lease expiration as the U.S. enters the 10th year of the current economic expansion. In addition, with an average investment per property of $2 million, our portfolio is highly liquid from a sales perspective and readily fungible from a leasing standpoint, which is an important differentiator for Essential.
Based on our experience, there are a larger number of prospective tenants interested in and capable of leasing smaller properties, and there is an exponentially deeper pool of buyers for lower price point assets. This inherent granularity serves to facilitate our active asset management philosophy and further diversifies our risks. These favorable portfolio metrics are a direct output of our strict adherence to a disciplined investment strategy, which reflects the many lessons learned over our senior executive team's 50+ years of experience managing and investing in single-tenant net lease properties. In our view, we have one of the most durable and recession-resistant portfolio in the net lease industry as we have freshly underwritten the properties and tenants in our portfolio and intentionally avoided many of the at-risk sectors that are more commonly found in seasoned net lease portfolios.
With that in mind, we generated same-store contractual NOI growth of 2% in the third quarter, which is indicative of the health of our tenancy and the contractual rent escalations that we structure into our long-term leases. Turning to our third quarter investment activity. We invested $133 million in 62 high-quality net lease properties at a weighted average initial cap rate of 7.7%. As a percentage of cash ABR, approximately 77% of our third quarter investment activity came via sale leaseback transactions. 58% were subject to master lease provisions, and 100% are required to provide us with corporate and unit-level financial reporting on a regular basis. Year-to-date, we have invested $412 million in 176 net lease properties at a weighted average cash cap rate of 7.7%, which compares to $374 million at a 7.6% weighted average cash cap rate for the same period last year.
As a percentage of our cash ABR, approximately 84% of our year-to-date investment activity involved direct sale leaseback transactions. 57% was subject to master lease provisions, and 98% are required to provide us with corporate and unit-level financial reporting. These statistics speak to the quality, consistency, and selectivity of our investment discipline and our longstanding industry relationships, as roughly 93% of our year-to-date investments represents relationship-based investment activity from our senior management team. From a tenant health perspective, our portfolio has a strong weighted average rent coverage ratio of 2.8x , and over 72% of our cash ABR has a rent coverage ratio of 2x or better. Based on our historical data, a tenant with over 2x rent coverage has a high probability of not only renewing their leases at maturity, but staying committed to the property that we own.
With that in mind, as disclosed on page 11 of our third quarter supplemental, only 0.7% of our ABR has unit level rent coverage below one times, and less than 1% of our leases expiring through to 2026 have unit level rent coverage below 1.5x . We believe this ongoing disclosure provides unique visibility into the health and profitability of the tenants that operate in our properties. Coupled with the fact that our entire portfolio was purchased within the last two and a half years, we believe there is a high degree of predictability and security to our rental revenue. Looking forward, our quarter end cash balance of $74 million and our low leverage at 4.7x net debt to annualized adjusted EBITDAre give us ample liquidity to capitalize on our robust investment pipeline well into 2019.
As we look out to the first half of next year, we will continue to source granular investment opportunities, allowing us to accretively deploy capital into single-tenant properties, primarily originated through sale leaseback transactions with master lease provisions. However, given the recent volatility in interest rates and the equity markets, we will be highly selective towards new investment activity to preserve our capital and capitalize on the investment opportunities with the best risk-adjusted return. Consistent with last year, the first quarter tends to be seasonally slow for our investment activities, so you should expect our investments pace to moderate in the first half of next year. Turning to guidance.
We are providing our 2019 AFFO per share guidance range at $1.11-$1.15, which implies 13% growth at the midpoint when annualizing our third quarter AFFO per share of $0.25, which was our first full quarter as a public company. This guidance range contemplates a wide array of scenarios, and we feel it is prudent not to offer more specificity around assumptions, given the volatility in our cost of capital and the fact that our equity has been publicly traded for less than five months. With that, I'd like to turn the call over to Hillary Hai, our CFO, who will take you through the numbers. Hillary?
Thank you, Pete, and good afternoon, everyone. Starting with the balance sheet, we ended the quarter with $517 million of debt related to our master trust funding program and $74 million in cash and restricted cash. Our net debt to annualized adjusted EBITDAre was 4.7x at quarter end, which gives us ample capital capacity to continue to execute our external growth plans well into 2019. Turning to the income statement. Our third quarter net income was $7.7 million or $0.12 per share. Nareit-defined funds from operations or FFO was $15.8 million or $0.25 per share, while adjusted funds from operations or AFFO was $15.6 million or $0.25 per share. One item to note is that we received $655,000 of interest income from outstanding cash balances in the third quarter, which should materially decline in the fourth quarter as we deploy our cash into new investments.
On the G&A front, we continued to increase our operating efficiencies as G&A for the third quarter declined to 13.7% of total revenue as compared to 17.2% a year ago. As our portfolio continues to grow in scale, we expect to see our G&A as a percentage of total revenue to sequentially moderate as we have the necessary infrastructure in place to execute our future business plan. Subsequent to quarter end, we paid our first dividend as a public company, which combines our third quarter dividend of $0.21 per share and our second quarter sub-period dividend of $0.00014 per share. Using our third quarter dividend of $0.21 per share, our AFFO dividend payout ratio was 84% for the third quarter, and we would expect to see that ratio decline over the coming quarters.
Lastly, as Pete mentioned, we are introducing our 2019 AFFO per share guidance at a range of $1.11-$1.15, which implies 13% growth at the midpoint when annualizing our third quarter AFFO per share of $0.25. Given the evolving nature of our cost of capital, we are not providing future projections on investment activity. As will be customary going forward, we are also not providing guidance on our capital markets activity. But as we stated at the time of our IPO, we intend to maintain a conservative view on leverage. Our long-term leverage goal is to remain under 6x, and we expect to end 2019 within that guideline. With that, I'll turn the call over to Gregg Seibert, our COO.
Thank you, Hillary. During the quarter, we invested $133 million in 62 properties at a weighted average cap rate of 7.7%. The weighted average lease term of these properties was 16.1 years, and the weighted average annual rent escalation was 1.7%, and our average property size was $2 million. As has been the case over the last eight quarters with our investment activity, which we detail on page seven of our supplemental, the majority, or approximately 77%, of our third quarter investments were originated through direct sale leaseback transactions that are subject to our lease form with master lease provisions and ongoing financial reporting requirements. This is a hallmark of our investment platform at Essential Properties. We seek to capitalize on our longstanding relationships in the net lease space to consistently source opportunities that fit our investment parameters and offer attractive risk-adjusted returns.
From an industry perspective, restaurants remain our largest sector at 27% of cash ABR, with quick service restaurants, or QSRs, being our largest industry at 15%. We believe the QSR industry provides a combination of stable industry performance and attractive real estate fundamentals, which makes it one of the best performing sectors in our experience. In fact, we sourced more than one-third of our quarterly investments from the QSR industry through both sale leaseback transactions and opportunistic existing lease deals, of which 77% included some form of lease amendment. Conversely, our 11.5% aggregate concentration in casual and family dining has declined 640 basis points over the last two quarters, which we have achieved through portfolio growth and capital recycling. From a tenant perspective, QSR chain Captain D's remains our only tenant over 5% of cash ABR, and we anticipate this concentration moving below 5% by early next year.
With that in mind, exposure to our top 10 tenants sequentially declined 360 basis points to 35% of cash ABR at quarter end, which will continue to ratchet down over the coming quarters. Looking at our portfolio more broadly, approximately 91% of our cash ABR at quarter end was derived from tenants that operate service-oriented and experience-based businesses, which has been a deliberate focus for Essential since we started acquiring properties over two and a half years ago. We believe tenants that are focused in these industries, and more importantly, real estate occupied by these tenants, are recession resistant and heavily insulated against e-commerce pressures. Moving on to asset management. Our portfolio remains healthy, with a weighted average rent coverage of 2.8x and over 72% of our cash ABR having a rent coverage ratio of 2x or better.
With 97% 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 of our active asset management approach. From a lease expiration standpoint, only 2.3% of our leases, as measured by cash ABR, are coming due between now and the end of 2021, and the vast majority of those expirations have coverages above 1.5x . With our average asset size being $2 million, our portfolio is mostly comprised of highly fungible, granular properties that facilitate our re-leasing and disposition efforts. We sold 21 properties during the quarter for $19.4 million in net proceeds, which resulted in a gain on sale of $1.5 million.
Excluding one leasehold property from our GE seed portfolio that had limited remaining term on the ground lease, the cash cap rate on the 16 leased properties that we sold during the quarter was 6.8%, which we believe is a conservative measure of value for our portfolio, as many of our sales in the quarter were weaker performing assets relative to our overall portfolio. I will turn it over to Pete for his concluding remarks.
Thanks, Gregg. We believe we have assembled an attractive portfolio of single-tenant properties that are well insulated against e-commerce pressures
By concentrating on small fundable properties, primarily leased to tenants in service-oriented and experience-based industries. In addition, we prefer investing into situations where the seller or tenant ascribes a premium to our reliability as a capital partner and landlord, having fostered these relationships over hundreds of transactions and billions of dollars of investments. In doing so, we have built a portfolio that is incredibly efficient to manage and has unprecedented transparency. As we look forward, these two factors, a newly constructed portfolio and a value-add relationship-based investment approach, should provide the foundation for compelling growth for shareholders. With that, operator, we'll take our first question. Thank you.
Thank you. At this time, we'll be conducting a question-and-answer session. If you'd 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'd 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 Sheila McGrath with Evercore. Please proceed with your question.
Yes, good afternoon. Pete, I was wondering if you could give us an update on how fourth quarter is tracking so far in terms of investment volumes.
Sure thing, Sheila. If you look at our Q, which we filed today, you'll see that in subsequent events language in the Q, we've deployed about $15 million so far in the quarter. We have a robust pipeline. As I said in the prepared remarks, we're certainly going to be pretty cautious as we go into the fourth quarter here and would expect it to be somewhat lighter from our historical average.
Okay, that's helpful. Then can you remind us of what your longer-term thoughts on putting an ATM in place? Do you have to be public for a certain amount of time before you can execute on an ATM?
Sure. We would generally issue shares on our ATM off of a shelf registration. We wouldn't be eligible to put that in place until being public for a full year, which would put it in early July of next year.
Okay.
From my perspective, I think the ATM's an excellent tool for us and really a great way to raise equity that match funds the way we invest our dollars. So, to the extent that we're eligible and we like our share price, you can expect us to use it.
Okay, great. One last question. If you could give us your bigger picture view on cap rate trends with rates moving higher.
Yeah, I think you can see we've provided in our supplemental a good view of our investment activity going back eight quarters. You'll see that we've been generally able to tick cap rates up at the margin with interest rates. Certainly, the interest rates have moderated a little bit here relative to a little earlier in the quarter. In general, we would expect to be able to inch our cap rates up as interest rates rise. I think that's part of the reason why you see us taking a more conservative stance here in the early part of the fourth quarter as we would act and look at the movements in the rates and sellers' adjustments and expectations.
Okay, great. Thank you.
Thanks, Sheila.
Our next question comes from Christy McElroy with Citigroup. Please proceed with your question.
Good morning. This is Katie McConnell on C. Can you walk us through some of the moving pieces that is driving the ramped 2019 AFFO guidance from Q3 levels, including your expectations around same-store NOI and rent growth in 2019 relative to the pace year-to-date?
Yeah, Katie. There's obviously a lot of levers in our business. A lot of the assumptions went into building the guidance range. Certainly, the deployment of our capital that we have, the leverage capacity as well as the cash from the same-store sales growth. We were happy to report 2% growth this quarter, which we feel is a somewhat elevated level. I think from a run rate perspective, we would expect 1.5%-1.7% on a normalized basis coming from an inherent escalation. That's kind of what's built into our leases. I would say, more specificity around guidance. We've made a lot of assumptions about the timing and amount of investments and the corresponding potential capital raises. I think the range we've given contemplates those, and we just need to see how the year unfolds.
Okay, great. Thanks for the thought.
Thank you.
Our next question is from Doug Harter with Credit Suisse. Please proceed with your question.
Hi, guys. This is actually Sam Choe filling in for Doug Harter. Pete, I think I missed the total percentage of master leases in the portfolio. What was that number?
As of 9/30, the number was 67% of our ABR is coming from Yep.
Got it. I see that I mean, the third quarter, the master lease percentage was 58%. From a portfolio quality diversification standpoint, is there a certain percentage of master leases you guys target?
We want to get as many master leases as we can. We certainly like the pooling effect and diversification of risk. We're not dogmatic in that, to the extent that we buy assets on individual leases. We underwrite that into our pricing and price that risk accordingly. You'll see it ebb and flow. If you look at our supplement, you'll see it ranges from kind of low 30 on up to high 80s or mid-80s, it really just depends upon the deals we were able to source in that individual quarter, and what it looks like. We're pricing each individual deal based upon the structure and the risks inherent in that deal. It varies, but in general, we like to get master leases, but if we can't get it, we certainly price it in.
I see. You're more concerned about the type of opportunities, the master lease is just one component of it.
Yes, certainly.
Got it.
Direct sale-leaseback is an important component of that, and that was mid to high 70s in the quarter, and that's an important number for us. 82% of our investments, excluding our initial transaction, have been direct sale-leasebacks.
Got it. All right. Thank you so much.
You got it, Sam. Thank you.
As a reminder, if you'd like to ask a question, please press star one on your telephone keypad. One moment, please, while we poll for questions. Our next question is from John Massocca with Ladenburg Thalmann. Please proceed with your question.
Good afternoon.
Hey, John.
Could you maybe provide some more color on the QSR properties you acquired in the quarter? Specifically, understanding QSR is a pretty hot asset class right now, so the cap rate's probably a little bit below-
the overall cap rate on your acquisitions. How far off maybe was it from the rest of your acquisition base, and are you still seeing strong demand for that asset type?
Yeah, I'd like Gregg to tackle that one. Gregg?
Sure. Thanks, Pete. Yeah, Jonathan, there were some historical relationships we had on some of the existing lease assets as an example, where we knew the tenant well, and we were able to extend their leases on a portfolio from a third-party seller and kind of get a significant amendment for things that we require, obviously, like more term financial reporting on the units. There's just opportunities, because we've been in the business so long, that occasionally come up. Specifically, I think Pete and I have been in the QSR sector probably since the mid to late 1990s. Occasionally, opportunities like that do come up from franchisees and franchisors.
I would say, John, because we're kind of working with the tenant to recast those leases, we were able to get those at an attractive cap rate, certainly relative to market. I would say it was slightly inside of the average, but certainly not well below.
Understood. It seems like you didn't really add too much to the existing kind of top 10 exposure in terms of doing any more transactions with those tenants. Is that a conscious decision in terms of trying to let more kind of diversity foster as you grow the portfolio, or was that just a consequence of a quarter of acquisitions and the deal flow being what it was?
Yeah, I would certainly say it's more the latter. In the second quarter, you saw us add three tenants to our top tenant mix, we're certainly trying to increase our diversity, and really keep any one tenant below 5%. More than anything, we're reacting to the deals that we're presented with and able to secure in a given quarter. It just so happens this quarter, there weren't that many large transactions presented.
Understood. One last one. It seemed like the convenience store segment was basically flat, and you sold a couple properties, or at least a couple properties fell off the list. Was selling those assets, or was that the result of maybe some kind of opportunistic sales? Any color around that would be helpful.
Yeah. We have a number of C-store operators that we work with that routinely present us with opportunities, to partner with them on new acquisitions and the sale-leaseback transactions. We're often able to turn around and sell some of those properties in the one-off market and realize a nice spread. Correspondingly free up more capacity to continue to invest with that tenant while maintaining that top 10 diversity that we were talking about on the last question. That was part of it in the quarter, where we bought some assets wholesale from a C-store operator, while we were simultaneously underwriting some new sale-leasebacks with them and recycling capital.
All right. One last one. On the guidance, understanding you're not giving specific kind of details on the assumptions, does both the high and low end assume acquisitions in 2019?
Yes, it does. We have a lot of cash to put to work with $74 million on the balance sheet at quarter end. We are in a leverage position well below our stated goal. We have capacity to continue to invest and grow the portfolio, rationalize G&A. The low end does contemplate putting that capital to work. I would say the variations in guidance really result from a timing perspective throughout the year.
Understood. That's it for me. Thank you very much.
Thank you, John.
There are no further questions. At this time, I'd like to turn the call back to Pete Mavoides for closing comments.
Great. Thank you, [Rob]. Thank you all for joining us on the call today. As I said at the outset, we're excited to get this quarter out. We think it was a great quarter for our team, with continued execution along all of the goals that we've set out, and more importantly, to give people a fresh look into 2019 in how we see the business playing out. Thank you again. We look forward to speaking with you all in greater detail at Nareit, have a great day.
This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation.