Greetings, welcome to the NNN REIT Q1 2023 Earnings Call. At this time, all participants are in a listen only mode, and 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. Please note this conference is being recorded. I will now turn the conference over to your host, Mr. Steve Horn, CEO of NNN REIT. Sir, you may begin.
Thanks, Ollie. Good morning, welcome to the inaugural NNN REIT Q1 2023 earnings call. Joining me on this call is Chief Financial Officer, Kevin Habick. As this morning's press release reflects, NNN's performance in the Q1 produced 3.9% core FFO growth, along with acquisitions slightly over $155 million, with a 7% initial cash yield. In addition, our portfolio retained a high occupancy of 99.4%, which I attribute to the upfront due diligence on property acquisitions and the continuous portfolio management that NNN does every day. Before we continue with the operational performance, I want to address the name change, which I'm excited about. First, as I stated in the press release, the change does not signal a strategy shift with acquisitions, balance sheet management with deliberate and consistent NNN.
We felt it was time to take advantage of the NNN brand. The reality is NNN is what we are called with our circle of investors, peers, clients every day. In addition, our website and emails use the NNN REIT brand. Therefore, the change is making NNN even more consistent within our sector. Turning to the highlights of the Q1 financial results, our portfolio of 3,449 freestanding single-tenant retail properties continued to perform exceedingly well. As I stated earlier, occupancy ended at 99.4 for the quarter, which is above our long-term average of 98%. Occupancy remained flat from year-end.
At the quarter end, NNN only had 20 vacant assets, which is 1 less than the year-end, which is a product of our leasing department enjoying a high level of interest by a number of strong national and regional tenants in our vacancies. 91% of our leases that were up for renewal during the quarter exercised an extension. I'm sure we'll cover more of the credit watch list in the Q&A, I just want to give a little bit more color. There are some large names that filed bankruptcy. Our portfolio is still performing at high levels, and we expect that trend to continue. One of the recent filings of Bed Bath & Beyond, which NNN currently owns 3 of their assets with an average rent of $13 per square foot.
We've been getting a lot of inbound interest on the assets because of the quality of real estate, so I expect when the time comes to release the assets, we'll have superior recovery rate in a timely manner. Remember, as I stated earlier, the average occupancy from NNN since 2003 is 98%. The portfolio has stood the test of time through GFC and COVID. Turning to acquisitions, we'll continue to be prudent in our underwriting, and NNN is afforded the luxury to continue to be selective. We acquired 43 new properties in the quarter for approximately $155 million, the initial cap rate of 7% with an average lease duration of 19 years. Almost all of our acquisitions this past quarter were sale-leaseback transactions. That is a result of the calling effort of our NNN acquisitions department.
NNN prides itself on maintaining the relationship business model, which we can do repeat programmatic business. With regard to the acquisition pricing environment, the last quarter of initial cap rate of 7% is approximately 40 basis points wider than the Q4 of 2022. As I mentioned during the February call, we were seeing cap rates steadily increase. Now as we sit here at the beginning of May, the cap rate increases are starting to plateau some.
What I mean, the rate of increase is definitely slowing down, so I'm not expecting another 40 basis points for the Q2 of 2023. This is resulting on NNN feeling that cap rates are starting to hit the glass ceiling, assuming the macroeconomic environment settles down. During the quarter, we also sold six properties that generated nearly $12 million of proceeds to be reinvested in new acquisitions.
The dispositions consisted of 3 vacant assets and 3 income-producing assets at a 6.6 cap rate. I do expect disposition activity to be greater in the Q2 , and we are keeping our disposition guidance unchanged for the year. As I finish up, and to remain consistent as past calls, Kevin and his team keep the balance sheet rock solid. We ended the Q1 with $209 million out on our $1.1 billion line of credit. No material debt maturities until 2024. Thus, NNN is in terrific position to fund the remaining of our 2023 acquisition guidance. In summary, the occupancy rate, leasing activity, the relationship-based sale-leaseback acquisition volume, we believe once again validated our consistent long-term strategy of acquiring well-located parcels, leased to strong regional and national operators at reasonable rents while maintaining a strong and flexible balance sheet.
As I stated earlier, NNN is in solid footing as we are a quarter into 2023. With that, let me turn the call over to Kevin for more color and detail on our quarterly numbers.
Okay, Steve. Thank you. As usual, I'll start with a cautionary statement. We will make certain statements that may be considered to be 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 these 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 in this morning's press release. Okay, with that out of the way. Headlines from this morning's press release report quarterly core FFO results of $0.80 per share for the Q1 of 2023. That's up $0.03 or 3.9% over a year ago, results of $0.77 per share, and that was flat with prior Q4 results.
Today, we also reported that AFFO per share was $0.82 per share for the Q1 , and that's also up $0.03 per share or 3.8% over Q1 2022 results. As can be seen in the footnote on page 1 of the press release, as well as the detailed deferred rent repayment schedule on page 13, the accrual basis, deferred rent repayments have now been virtually fully repaid and will not create any real noise in our AFFO number going forward. The scheduled cash basis deferred rent repayments continue to taper off materially in 2023, as can be seen again in the details provided on page 13 of the press release.
That slowdown produces about a $5.8 million or $0.03 per share headwind for the full year, which we obviously previously, I should say, just noted and is baked into our 2023 guidance. One last note on Q1 results. We did receive $1.7 million of lease termination income, and that's higher than normal and compares with $1.0 million in Q1 of 2022. Overall, a good quarter in line with our expectations. Moving on, our AFFO dividend payout ratio for the Q1 of 23 was approximately 67%. That created approximately $49 million of free cash flow. That's after the payment of all expenses and dividends for the quarter.
This free cash flow funded 31% of our total acquisitions in the Q1 and that's about half of the equity needed for those acquisitions, assuming we run a balance sheet at a roughly 60% equity and 40% debt on a gross book value basis. Occupancy was 99.4%, as Steve mentioned, at quarter end, and that's flat with year-end of 2022. G&A expense was $12.25 million for the quarter, and that represents about 6% of revenues. Our midpoint guidance for this line item is still $44 million for the full year 2023, which would put G&A closer to about 5.5% of revenues for the year.
We ended the quarter with $782 million of annual base rent in place for all leases as of March 31, 2023. Today, we did not change our 2023 guidance, but which we introduced in February. Q1 results might suggest we have the opportunity to be at the higher end of the guidance range, but we will revisit any guidance changes when we report Q2 results. The 2023 guidance and the key supporting assumptions are on page 7 of today's press release. Switching over to the balance sheet, we maintain a good leverage and liquidity profile with roughly $900 million of liquidity. The Q1 was fairly quiet in terms of capital markets activity.
We issued $17 million of equity in the Q1 , executing trades around $46 per share level. After a few years of nearly no usage of our $1.1 billion bank line of credit, we did begin to use it a bit in 2023, and that's was a part of our plan to navigate this rockier interest rate and capital market environment. Our weighted average debt maturity is about 13 years, including that bank line. All of our debt outstanding is fixed rate, with the exception of that, the $209 million on our bank line, which represents about 5% of our total debt. A couple of metrics. Net debt to gross book assets was 40.4%, which is flat with year-end.
Net debt to EBITDA was 5.3x at March 31st. Interest coverage and fixed charge coverage was 4.7x for the Q1 of 2023. We're in very good shape to navigate the elevated economic and capital market uncertainties and to continue to grow per share results, which we view as the primary measure of success. With that, we will open it up to any questions. Ali?
Thank you. At this time, we will 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 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. Thank you. Our first question is coming from Spenser Allaway with Green Street. You may proceed.
Thank you. You mentioned in your prepared remarks that the rate of cap rate increases has slowed, but can you just comment broadly on the different retail industries? Are there any segments that stand out as continuing to have a wider bid-ask spread, so cap rates haven't moved as quickly? To the contrary, any industries that, have seen cap rates move faster?
Yeah. How you doing, Spenser? Yeah. The cap rates really the second half of last year, you saw, slowly increased in a pretty good clip. What we're finding is the acquisitions in the Q2 Now you specifically asked what segments. Just think of whatever our portfolio is, that's the segments I'm really speaking of. If it's QSR, convenience store, auto service specifically, where we've done the most volume recently. You know, the large regional operators, non-investment grade tenants. Yeah, we're seeing a little bit of a plateau in the cap rates. They're acceptable cap rates, we picked up that 40 basis points. I'm kinda thinking more in the range of 20-30 basis points for the Q2 .
As we move out into Q3 , it's a little bit too early on the pricing. Assuming the economy stays where it is, I think we're kinda getting near the top of it right now currently.
Okay, that's helpful. Then the cap rates on the dispositions, those are pretty low for the Q2 in a row. Is there anything unique here driving that lower, than , prior quarters? Is there any reason to think that that could continue on future dispositions this year?
No. The dispositions, we're not changing our guidance for 2023. I'm expecting to hit that guidance range. It was a more of a timing issue, lower in the Q4 and the Q1. The stars are starting to align, where I'm expecting the Q2 to pick up pace a little bit. As far as our dispositions this quarter , the 3 vacancies and the 6.6 cap rate was a result of really 2 defensive sales, meaning one was a dark but paying rent asset we sold, and the other was an obsolete, I'll call it a gas station, not a convenience store. The third one was an opportunistic sale where somebody liked the property more than we did.
Okay. Thank you, guys.
Thank you. Our next question is coming from Joshua Dennerlein with Bank of America. You may proceed.
Hey, guys. It's Josh Dennerlein here. Could you remind us what the bad debt amount is assumed in guidance and how the Bed Bath & Beyond BK falls within that range?
Yeah, sure. This is Kevin. Yeah, so we assumed in our guidance as we have for a number of years, 100 basis points of rent loss in our guidance, and didn't really use any of that in the Q1 . As it specifically relates to Bed Bath & Beyond, our stores have not been closed or on the rejection list, and so we anticipate they will continue to pay rent up until that changes, if and when that changes. At the moment, we're not experiencing any notable level of bad debt at this point.
Okay. Interesting. They're not on the closure list or?
Correct. Yeah, they've announced, I think 480 total stores, 360 Bed Bath, 120 buybuy BABY, and our stores are not on that list.
Okay. Okay. Good color. Then I think just reading the 10-Q that came out this morning, there's another tenant in bankruptcy. I guess, can you update us on that tenant, the assets and then maybe what the rents are compared to the market?
Yeah. We really only have 2 in bankruptcy. One's Bed Bath, which we talked about, and the other is Regal Cinemas, which we've talked about in the past, which is, just 1 property and we'll see where that goes. They're still paying rent and we'll, negotiate that as that goes along, whether that survives or does not survive, time will tell. You know, very small in the scheme of things.
Okay. Appreciate that. Thank you, guys.
Thank you. Our next question is coming from Eric Roth with Citi. You may proceed.
Thanks. Good morning. Just starting with the guidance question , what takes you sort of from that run rate of $0.82 in the Q1 down to $0.80 for the rest of the year? I think you brought up some lease termination income, but it would seem like there's something else that gets you down there, other than the lease termination income.
Yeah, nothing really. I mean, I think , as I noted in my prepared remarks , we're clearly tracking for the high end of our guidance range. It was, a little bit of a discussion, or thought process here internally of whether we would think about revisiting our guidance. W e're just kind of measured and deliberate kind of people, we deferred that to the Q2 I did note, like I say, to your point, there's a $0.01 of unusual one-time kind of income, lease term income in the Q1 that helped results. We're not expecting that to continue.
Yeah, we like where we stand and hopefully with time, we'll be able to let the guidance drift higher, which is.
Has occurred from time to time over the years. Yeah, that's just the way went at it this time.
Okay. You mentioned that cap rate, you're hitting the glass ceiling around 7%, although I think you said that it might expand about 20, 30 basis points further. Just curious, at that level, sort of call it the low sevens type cap rate, how are you feeling about your ability to create value at that level, given your cost of capital? I noticed that you didn't raise much on your ATM in the Q1 , maybe that was just more timing related.
Yeah. I'll take care of the first part of the , talking about the cap rates hitting the glass ceiling. Yeah. No, we're expecting Q2 to expand off our 7%, cap rate and kind of what I said in the, opening remarks. Q3 is a little bit too early. You know, we'll deploy money at that, 7.25, 7.3 range. Kevin can talk about kind of the relation to our cost of capital.
Yeah, I mean, and we've talked about this, over the years, how we think about our weighted average cost of capital. I won't go into all the details at the moment, but it's in our pitch book. You know, we try to burden our cost of equity today at around an 8.5% kind of cost. For purposes of deploying capital, that's the kind of return hurdle we've set up internally as we think about deploying capital into new investments. What that ends up producing is a weighted average cost of capital, including debt, of in the low 7s. We feel like today that's what we need to earn to generate the sufficient and appropriate return for NNN shareholders.
Other people take different views around their cost of equity and all that kind of thing. Like I said, I won't go into all the details there. The good news is, for us, and that's why I kinda highlighted, our free cash flow funded half of our equity need, if you will, in the Q1 , just from operations. We really have a, in terms of raising additional capital, and that's before property dispositions, which would be another, 10-15% of our acquisition, fund equity funding for acquisitions.
At the end of the day, we need precious little new equity capital to kind of on a cash flow basis to kind of run the or achieve the guidance, acquisition guidance we're thinking of for the year. Having said that, the free cash flow we generated, the property disposition proceeds, in our minds, we burden that at a 8.5% cost as well. It's not free cash flow. It costs 8.5%. If we can't earn that kind of return on equity, then we probably are doing a disservice, in our opinion, to shareholders. We might should send it back to shareholders if we don't think it has a sufficient kind of cost to it.
That's just the way we think about it. Like I say, it's a little different than I think a lot of folks, but I think it's helped us being a little more disciplined over the years, and we like that approach.
Got it. Thanks for the detail.
Yep.
Thank you. Our next question is coming from Rob Stevenson with Janney. You may proceed.
Good morning, guys. Steve, back to the cap rate commentary that you were making before. How much does that differ, the movement between sale-leasebacks versus the one-off and small portfolios that may be more sensitive to all these issues with the banks these days?
Rob, good question. I mean , we don't play in, we call it 1031 market where there's the one-off. I mean, we have a dedicated acquisition guy that's always trying to find the diamond in the rough. As day-to-day operations, we do the sale-leaseback. The sale-leaseback market, the sophisticated clients have understood the capital markets or just the overall lending environment's a little more difficult for the middle market. They've migrated to the sale-leaseback, and they've allowed for the cap rate expansion. The 1031 market, where there's even more competition, if it's just doing the 1031 exchanges or just there's more cash buyers, they're not as sensitive to the bank lending market currently. Those cap rates haven't moved quite as much.
All that being said, if you played in the investment grade market and you were buying those deals, that you were buying at, high fours or low fives, you've seen a significant cap rate movement because they started off so low, historically the last couple of years. Sale-leaseback market, we're still seeing an increase for the Q2 , just not as fast of a rate.
Okay. How deep is that buyer pool today? I mean, if the seller doesn't like the price that you give them, they have 25 guys behind you willing to do that price? Is that buyer pool for those sale-leaseback transactions sort of thinned out as well, given rates and other issues?
The, kind of the same storyline. You know, I've been in the business here at NNN REIT for 20 years, and we've been highly competitive market from day one. Just the names have changed over the course of the years. There's a few less buyers in the market currently that relied on the kind of secured loans, but it's still highly competitive. Nobody's stealing assets. It's market pricing currently. If somebody doesn't like my pricing, there's somebody right behind me that's willing to do it.
Okay, that's helpful. Kevin, given all that's gone on with the bank term loan market as well as interest rate hedge pricing, where is your best debt access today? What is that costing you today?
Well, Rob, it's funny today, everything pretty much costs the same roughly, or at least in the scheme of things. Bank lines are close to 5.5%, 10-year debt's close to 5.5%, and 30-year debt's not a whole lot more than that. Today , it's really, any decision around the term of debt you might be using or issuing is a bit of a bet on where rates will be , 2 years or 4 years from now.
Like I said, we chopped a lot of wood on long-term debt and, prior years, particularly in 2021, and pushed our weighted average debt maturity pretty far out, and for the last several years really have not used our bank line. We've our approach has been to pivot somewhat to use our bank line, which has been virtually unused, we have the flexibility to do that and let this interest rate cycle play out a bit, and see where rates go, call it 1 year from now, and make a maybe a longer-term bet on interest rate direction. That's, that's the way we're kind of playing it at the moment.
Having said that, I'll say, A, we don't give guidance on our capital markets activity, and B, I reserve the right to change my mind. Hopefully, I've been sufficiently elusive, so.
Okay, fair enough. It's helpful. Thank you, guys. Appreciate the time.
Thanks.
Thank you. Our next question is coming from Wes Golladay with Baird. You may proceed.
Hey. Good morning, everyone. Are you seeing any signs that the tenants will pause expansion due to the macro uncertainty?
Go ahead and say that again, Wes? Kind of broke up.
Yeah, are you seeing any signs that your current tenant roster, the ones that you're growing with, will pause their expansion plans due to the macro uncertainty?
I think what we're seeing out there right now, our development pipeline is, really high , compared to historical basis. We're not seeing a slowdown as far as, them picking and choosing, expansion as far as individual sites. What we're seeing is, it's more not really the economic uncertainty of their customer, it's more the debt lending, side of things that the M&A activity we're seeing slow down. There's not many doubles or home runs in the M&A market that we're seeing that our tenants are picking up. It's kind of more base hits where they're doing one or two site bolt-on acquisitions. Now what we're afforded the luxury is that we don't need the home runs here at NNN.
That the pool that we are shopping in is plenty big for us to hit our targets.
Okay. Then, Kevin, I wanna go back to your comments about the how you view your weighted average cost of capital. I think you said it was in the low sevens in your... Currently it's currently where you're buying. Have you historically tried to target a spread over that? Or do you just view that, "Hey, we're buying better quality, and the overall quality mix is being transacted at our weighted average cost of capital," and that's sufficient?
Yeah. Yeah. I know I'm swimming upstream on this 'cause that's the vernacular of our industry, is to think about a spread above your cost of capital. I think the way a lot of folks get to a spread above their cost of capital is they just take a low view as to what kind of return on equity hurdle that they need to meet. In our pitch book, we use that example. You know, if you think your cost of equity is 5.5%, to pick a number, then you come out with a weighted average cost of capital today, close to 5.5%. That's not far from that. You think, your cost of capital is very cheap. We for...
Again, this is not. We divorce sourcing capital from deploying capital. Look, I understand those two things get connected eventually, but we try to layer on a level of extra discipline, if you will, of burdening our cost of equity for purposes of deploying capital at about an 8.5% cost. If you fully burden your cost of equity, you don't really need a spread above that because you're earning enough. You're justifying. That's what the hurdle rate's there for, is to say, what do we need to earn to sufficiently compensate NNN shareholders? We have...
Answer your question, we typically have not had a big spread above our cost of capital, but it's been that way because we burden our equity at a higher rate than most other companies do, and we've set that hurdle there. I think it leads to the better outcomes in the long run. You know, in the past, call it two years ago, when, the world was awash with money, we burdened our cost of equity at about an 8% return, and our cost of debt was a whole lot lower, and our weighted average cost of capital, in our minds, was about a 6% level. That's what we said was the return, requirement for NNN shareholder then.
You didn't see us do virtually any sub-6 cap rate deals, call it 2 years ago. The world's changed, interest rates are up. We've raised our return on equity hurdle, and so now we're targeting kind of a low 7s kind of return.
Fully and sufficiently compensate our shareholders. Again, this is for purposes of deploying capital. When it comes to sourcing capital, we really take a little bit different view, and we try to get capital when it's available and well-priced, almost irrespective of need. We know we'll use it eventually, but that's just the approach we take. Like I say, we've been doing this for , kind of consistently for a long time, but we do go about it a little differently. So we never really get into the vernacular of a spread over our cost of capital because we really put an extra burden on our equity return hurdles that I think compensates for that. Anyway. Sorry, that was a long-winded answer to your question.
No, I appreciate it. Yeah, thanks for the detailed answer, Kevin.
Thank you. Once again, if there are any remaining questions, please press star one on your phone at this time. Our next question is coming from John Massocca with Ladenburg Thalmann. You may proceed.
Good morning.
Good morning.
Maybe building a little on Wes's first question. As you kind of think about what your tenants are using, new dollars or investing with them for, what's kind of the broad broad breakdown between expansion and maybe refinancing?
It's definitely skewed towards expansion currently. Our tenants haven't. It's still early, on, we're 1 year into it, that we're not seeing our tenants having to refinance debt. You know, most of our tenants, it's a business model decision to do sale-leaseback financing. They believe in not owning real estate because they understand they can take that equity, put it into operations, and then make a higher margin selling a service or a good that they're selling, opposed to the increased value of real estate. We don't do a lot of refinancing. Historically, we've done a lot of M&A financing and bolt-on acquisitions and new store development. It is the vast majority of where we deploy capital.
Okay. You talked about it a little bit in terms of Bed Bath & Beyond, but maybe more generally, what's the demand like out there for vacant assets, vacant boxes, et cetera?
Out of the 20 current vacant assets that we have, we have about activity around a little over half of those assets right now, which is a little bit to my surprise, John, how much activity we've had. 'Cause typically when it's a vacant asset, it's not our best real estate in the portfolio. We don't get that back. Yeah. No, there's definitely some movement of the smaller regional or even the mom-and-pop operators taking our vacant assets.
I guess, I mean, how does that activity number compare to, pre-pandemic or, earlier years?
It's definitely elevated right now that we're seeing more activity with our vacant. You know, first and foremost, we always try to re-lease our vacant. After a certain amount of time, it's not realistic to hold on to vacancies. You know, you just got the overhead drag, and we'd rather just sell them, even though it might not be top dollar, and then redeploy that money creatively into acquisitions.
Okay. That's it for me. Thank you very much.
Thanks.
Thank you. It appears we have reached the end of our question and answer session, so I will now turn the call back over to Mr. Horn for closing remarks.
Thank you, Ali. NNN's in a great position here, heading into the Q2 . I look forward to it. Thanks for joining us this morning, and look forward to seeing many of you in person in the upcoming conference season, specifically, ICSC and NAREIT. Thanks for joining.
Thank you. This does conclude today's conference, and you may disconnect your lines at this time. We thank you for your participation.
Thanks.