Good day, and welcome to the Phillips Edison & Company second quarter 2023 earnings conference call. Please note that this call is being recorded. I will now turn the conference over to Kimberly Green, Head of Investor Relations. Kimberly, you may begin.
Thank you, operator. I'm joined on this call by our Chairman and Chief Executive Officer, Jeff Edison, our President, Devin Murphy, and our Chief Financial Officer, John Caulfield. Once we conclude our prepared remarks, we will open the call to Q&A. After today's call, an archive version will be published on our website. As a reminder, today's discussion may contain forward-looking statements about PECO's view of future business and financial performance, including forward earnings guidance and future market conditions. These are based on management's current beliefs and expectations and are subject to various risks and uncertainties as described in our SEC filings, including in our most recent Form 10-K and 10-Q. In our discussion today, we will reference certain non-GAAP financial measures.
Information regarding our use of these measures and reconciliations of these measures to our GAAP results are available in our earnings press release and supplemental information packet, which have been posted to our website. Please note that we have also posted a presentation with additional information. Our caution on forward-looking statements also applies to these materials. I'd like to turn the call over to Jeff Edison, our Chief Executive Officer. Jeff?
Thank you, Kim, and thank you, everyone, for joining us today. Before we get into our results for this quarter, I would like to acknowledge the recent two -year anniversary of PECO's IPO. I would also like to highlight the progress the PECO team has made during this period and reiterate our optimism for the future and our long-term growth plans. PECO's strategy remains simple and consistent. We exclusively own and operate grocery-anchored neighborhood shopping centers. More than 30% of our rents come from our grocers. On average, customers visit our grocers nearly 2 times a week. We are 98% occupied, which gives us strong pricing power. Leasing demand is at historically high levels for our in-line spaces, and we have limited exposure to big box retailers. We are lowly levered with a great balance sheet and well-positioned for accretive acquisitions in a highly fragmented market.
These components have not changed. We remain focused on owning shopping centers anchored by the number one or two grocer within a market. Our neighbor base has an omnichannel strategy, and more than 70% of our rents come from neighbors selling necessity, goods, and services. Our centers are situated in targeted trade areas with favorable demographics, where our top grocers make money and our neighbors are successful. Each of these components remain critical to our success. We continue to believe that format drives results. Our average center is 115,000 sq ft, which is the smallest in the REIT shopping center space. This enhances our pricing power. Our smaller centers allow for better FFO growth because they yield higher retention rates and strong leasing spreads. Our retention rates averaged 87% between 2017 and 2021.
Today, retention is at 94%, reaching a record high of 95% in the first quarter of 2023. High retention rates result in less downtime and lower tenant improvement costs. Lower capital costs result in better returns. From 2017 to 2020, our average cash leasing spreads were 8.8%, providing a meaningful avenue for NOI growth. Combined, comparable rent spreads for new and renewal leases were 10.1% in 2021. Today, we are executing record-high renewal spread rates of 17.7%, new rent spreads north of 25%, and 18.9% rent spreads when all combined. At the time of the IPO, PECO's total portfolio occupancy had exceeded pre-COVID levels and was at 96% leased. Today, leased portfolio occupancy is at a record high 98%.
Since the IPO, we have pushed annual rent bumps in our new and renewal leases from 2% to nearly 3% on average. Additionally, our smaller format centers and lower exposure to secondary anchors require less CapEx than other retail real estate formats. Lower CapEx leads to higher AFFO. Over 30 years, we have built a fully integrated operating platform and become one of the nation's largest owners and operators of neighborhood grocery anchored shopping centers. We continue to deliver on the operating side, which is reflected in our consistently strong financial results. Since the IPO, we have exceeded market expectations for NOI, FFO, and AFFO growth. The quality of our performance is an important differentiator. As a reminder, we define the quality of our performance and our portfolio through the use of the acronym SOAR. This includes Spreads, Occupancy, the Advantages of the markets we're in, and Retention.
PECO has a strong track record of external growth through acquisitions. We have selectively acquired new assets that fit our focus strategy. At the time of the IPO, we told you our plan was to purchase $1 billion of assets over the next three years. Since then, the markets have changed. We cannot control the markets, but we can control our response to them, which remains extremely disciplined and opportunistic. The transaction market continues to be fragmented and sporadic, as we saw with the dramatically lower volume of activity in the first half of the year. While we are currently seeing activity increasing, we believe cap rates are still adjusting slowly in the private markets in response to the higher interest rates. There are still gaps between buyer and seller expectations.
As we sit here today, we are reiterating our guidance for $200 million-$300 million of net acquisitions this year. That said, if the market remains inconsistent, as we saw in the first half of the year, we may be at the low end of that range. We have a very disciplined acquisition process. We remain focused on accretively growing our shopping center portfolio at the right price, while achieving our acquisition hurdle of a 9% unlevered IRR. For the remainder of this year, we remain confident in our business plan as reflected in our guidance increase. Looking beyond 2023, we believe our portfolio can deliver mid to high single digit FFO per share growth on a long-term basis, given our internal and external growth drivers.
In addition, we still have one of the lowest levered balance sheets in the shopping center space, which gives us the financial capacity to meet our acquisition objectives. The IPO is a major milestone for our company, but it was just the beginning. We remain focused, motivated, and committed to successfully executing our growth strategy, which we believe continues to generate more alpha and less beta. I will now turn the call over to Devin. Devin?
Thank you, Jeff. Good afternoon, everyone, and thank you for joining us today. The PECO team delivered another solid quarter of growth, with same center NOI increasing by 5.3%, and our portfolio reaching new record highs in both occupancy and renewal rent spreads. The consistency of our operating performance is attributable to our differentiated and focused strategy of exclusively owning grocery-anchored neighborhood shopping centers, anchored by the one or two grocer in a market, and our platform's ability to drive results at the property level through our integrated and cycle-tested team. PECO's leasing team continues to convert strong retailer demand into higher occupancy levels and rents. The retailer demand we continue to see is driven by the positive impact of the macro trends of hybrid work and suburbanization.
Our anchor occupancy increased 10 basis points sequentially to 99.4%, and in-line occupancy increased 50 basis points sequentially to a record high of 94.8%, representing year-over-year increases of 70 and 160 basis points, respectively. Leasing activity remains strong, and our volume of deals executed in the first half of the year increased year-over-year to 548 leases, totaling over 2.6 million sq ft. We continue to capitalize on strong renewal demand and are making the most of the opportunity to strengthen key lease terms and drive renewal rents higher. Specifically, for the second quarter, we achieved a 17.7% increase in renewal rent spreads, an all-time high. In terms of new lease activity, we continue to have success driving meaningfully higher rents in our portfolio.
New rent spreads for the second quarter increased 25.1%. We expect that leasing spreads will continue to be strong through the balance of this year and into 2024. Our pricing power is the driver of these metrics, and we do not see this changing in the near term. Our ongoing success in leasing continues to be driven by the strong demand for space across our grocery-anchored portfolio. Demand that continues to come from necessity and service-based neighbors. Currently, we see leasing demand primarily from restaurants, health and beauty neighbors, and medical neighbors. Restaurants represent 40% of our leasing pipeline activity today, half of which are quick service restaurants such as Dunkin' Donuts, Zaxby's, and Firehouse Subs. Health and beauty services are 11% of current leasing demand.
Medical, or Medtail, as we call it, is a fast-growing use in PECO's neighbor mix, and we continue to see strong demand for medical uses. Medtail currently represents 6% of our ABR, but 20% of our current leasing pipeline. PECO's retention rate remains strong at 94% in the second quarter. High retention rates mean no downtime and less tenant improvement costs, which leads to higher stabilized yields in our assets. As a reminder, our TI spend on renewals over the last five years averaged less than $2 per square foot and averaged just $1.35 per square foot in the second quarter. On average, our new and renewal inline leases executed in the second quarter had annual contractual rent bumps of 2.6%, another important contributor to our long-term growth rate.
We continue to invest in our value, creating ground-up outparcel development and repositioning projects, which remain a good use of our free cash flow and deliver attractive returns. Year- to- date, we have stabilized seven projects, delivering over 175,000 sq ft of space to our neighbors and incremental NOI of approximately $2.1 million annually. These projects provide superior risk-adjusted returns and have a meaningful impact on our long-term NOI growth. For the full year of 2023, we now expect to invest $35 million-$45 million in ground-up outparcel development and repositioning opportunities, with average estimated underwritten cash on cash yields between 9% and 12%. We have delayed construction starts for four projects that were originally planned to commence in the second half of this year.
That will now be pushed into 2024, lowering our expected spend in 2023 by approximately $15 million. We continue to enjoy the many benefits of PECO's grocery-anchored portfolio with our healthy mix of national, regional, and local retailers. More than 70% of our rents come from neighbors offering necessity-based goods and services, and our top grocers continue to drive strong, recurring foot traffic to our centers. Our local neighbor health remains strong. Local neighbors, which represent 26% of our ABR, continue to thrive in PECO's portfolio, benefiting from the continued strong foot traffic created by our grocer anchors and the strength of our neighborhood locations. The math behind our local neighbors continues to be positive and is improving. Our local neighbors have been in our centers an average of nine years.
This length of tenancy compares favorably to the capital investment average payback period of just 10 months. As of the second quarter, we have retained 78% of our local neighbors, an increase from 76% historically. Renewal rent spreads for our local neighbors were 23% for the quarter, compared to 18% for the overall PECO portfolio. In addition to the compelling economics behind our local neighbors, they differentiate our centers and offer a unique merchandising mix for our customers. We want to emphasize that successful local entrepreneurs prosper in PECO's grocery-anchored neighborhood centers. We continue to benefit from a number of positive macroeconomic trends that create strong tailwinds for us and drive strong neighbor demand. These trends include a healthy consumer, hybrid work, migration to the Sun Belt, population shifts that favor suburban communities, and the importance of physical locations in last mile delivery.
These demand factors are further amplified due to limited new supply, given the lack of new construction in our space over the last 10 years and going forward, given the economic returns associated with new construction. I'd now like to turn the call over to John. John?
Thank you, Devin. Good morning, and good afternoon, everyone. I'll start by addressing second quarter results, provide an update on the balance sheet, and then speak to our increased 2023 guidance. Second quarter 2023 NAREIT FFO increased 6.7% to $75.9 million, or $0.58 per diluted share, driven by an increase in rental income and our strong property operations. Second quarter core FFO increased 8.2% to $77.7 million or $0.59 per diluted share, driven by increased revenue at our properties from higher occupancy levels and strong leasing spreads, partially offset by higher interest expense. Our second quarter 2023 same center NOI increased to $99 million, up 5.3% from a year ago.
This improvement was primarily driven by higher occupancy and an increase in average base rent per square foot, driven by our strong leasing spreads, partially offset by lower collectibility reserve reversals in the current period when compared to 2022. From a balance sheet perspective, we ended the quarter with approximately $629 million of borrowing capacity available on our $800 million credit facility. Earlier this week, we extended all of our 2024 term loan maturities into 2026 and 2027. The 2026 term loan has two 12-month extension options that allow us to push the maturity into 2028 at our election. This enhances our already strong liquidity position and maintains our well-laddered debt maturity profile.
These term loan extensions improve our debt maturity profile, maintaining our financial flexibility, and allow for a lower cost of capital as we navigate the current debt capital markets. We appreciate the continued support of our banking partners. As we look at our floating rate exposure, 19% of our debt is currently floating and is influenced by our use of the revolver. We plan to limit our floating rate debt to less than 10% of our total debt, and we're currently working on alternatives to meet this target. Our leverage ratio continues to be strong as a result of our solid earnings growth, as well as our prudent balance sheet management, with our net debt to adjusted EBITDA at 5.2x as of June 30th, 2023.
At the end of the second quarter, our debt had a weighted average interest rate of 3.9% and a weighted average maturity of 4.6 years, when including the refinancing activity from this week and available extension options. 81% of our debt was fixed rate. Between the free cash flow generated by our portfolio and the significant capacity available on our revolver, we remain confident in our ability to fund our growth plans. Turning to our updated guidance, based on our performance to date, we're raising our NAREIT FFO and core FFO per share guidance. Our new core FFO guidance increased to a range of $2.30-$2.36 per diluted share. We're also increasing our same center NOI guidance to a range of 3.75%-4.5%.
These increases are a result of strong property performance, driven by leasing spreads, record occupancy, and high retention. With that, we look forward to taking your questions. Operator?
Thank you. We will now begin the Q&A session. If you wish to queue up for a question, you may press star one on your telephone keypad, if you wish to remove yourself from queue, it is also star one. One moment, please, for your first question. Your first question comes from the line of Caitlin Burrows of Goldman Sachs. Please go ahead.
Hi. Good afternoon, everyone. I know addressing your 2024 debt maturities was a goal of yours for this year, so congrats on getting that done. Now, your weighted average maturity of debt is 4.6 years, up from 4.1. Maybe you could talk a little bit about your outlook and opportunity from here regarding, kind of the ability to extend that further.
Sure. hey, good afternoon, Caitlin. It was a big project that we worked on and are very grateful for the support of our lenders and the ability to, to push that out, which just further gives us flexibility. With the limited amount that we have on the line in a, in a full acquisition plan for the remainder of the year, we continue to evaluate, additional financing alternatives, and that will help us further extend that. I, I think, you know, we'd like the bond market to see more activity. I mean, obviously, the base rates are, are higher, but, you know, that is-- we want to be a long-term, unsecured bond issuer.
We also have flexibility in the secured markets or, or other, you know, financing vehicles available.
Okay. maybe just on the acquisition side, I think, that's a unique earnings driver for PECO versus peers in particular, but the lower transaction volumes year-to-date for the industry and for PECO has limited that positive driver. I guess, could you talk about how the transaction opportunities have developed, year-to-date, kind of the pace of, deals you're seeing, what you've worked on, what you've passed on, and kind of your expectation for finding attractive opportunities in the second half?
Sure, Caitlin. Sorry about that first question. I was on mute. I gave a great answer, though. John, John filled in well. Yeah, the, the, you know, as you know, we're, we're in a difficult acquisition market. We, you know, we're happy we bought $80 million worth of properties in the first half of the year. You know, as, as you know, we've, we've stayed very disciplined in terms of what our underwriting is on those properties and making sure we're getting those centers that have the number one or two grocer in it, and where we can really drive rents and, and, and occupancy. We, you know, we're gonna continue to have the discipline we've had.
You know, the markets, in our, in our view, are starting to loosen a bit, and we're seeing a lot, a lot more price recognition than we saw during the last quarter and a half. We, you know, we are generally, I would say, cautiously optimistic about acquisition pace in the second half of the year. It's early, and it's, it's early days, and, yeah, I, I would say that there is a significant beta in terms of where we would end up again, on a short-term basis over the next, you know, couple quarters. You know, we probably-- you know, there, there's a pretty big beta there of where that could end up. That's why we, you know, we feel like we'll, we'll, we'll certainly...
We're, we're working hard to get to that into the range. Whether we're at the high end or the low end of the range is really gonna depend a lot on how the market continues to evolve. We have one project today, you know, under contract, that will close probably in the next, you know, two weeks. Not, not a big project, a smaller project, but we still have so we have a lot of work to do to get there. I would say generally, we feel like the market's moving in a positive direction for us to be able to meet those targeted goals.
Thank you. Your next question-
Dev, I don't know if you have anything to add to that?
No, nothing to add.
Thank you. Thank you. Your next question comes from the line of Jeff Spector of Bank of America. Please go ahead.
Great, thanks for taking the questions. Just to follow up on the acquisitions, I'm sorry if I just missed this, but did you provide specifics on, I guess, where cap rates are versus, again, what you're looking to acquire at? Like, how, how has the gap been narrowing?
Jeff, well, thanks for, for the question. We, we didn't really talk specifically yet about the, the, the narrowing. I think our-- you know, we, we think that there's been 50-100 basis points movement in, in cap rates. As you know, we're, we're really focused on getting long-term returns and it create-- and, and, you know, be, having our, our acquisitions be accretive, you know, early in their life. And so we're, you know, we're, we're more focused on that. You know, getting to a nine on levered is not, you know, an easy task in today's environment. You know, as cap rates have moved out, and as the, you know, sellers have come to recognition of the new pricing, we, we are seeing more product coming onto the market.
We think that that will, you know, allow us to, to, to get into the range that we, we've talked about on the acquisition side. I, I would say 50 to, you know, our 50-100 basis points movement in cap rates is probably a pretty good approximation, as we know that there's a, there's a wide- there's a wide spread in terms of those things. In terms of just sort of generally, an average property, I think that's a way, a, a fairly good way of, of, factoring in on where, where that pricing has changed.
Okay, thank you. Second question is on the gap between leased and economic occupancy. It narrowed this quarter to about 60 basis points. How should we think about that for the second half of the year into 2024?
John, you want to take that one?
Sure. Hey, Jeff. Our long-term historical average has been 60 basis points over years, and it widens, and, and I think at one point in the last year or so, it's gotten to 100 basis points. It really is pretty consistent at the 60 basis points. The reason for that is that because the majority of our leasing, the vast majority is of our new leasing is, is in line, we're able to get those spaces, you know, up and open, and rent paying faster than if we had more box activity. I would say that as we look forward, I think that 60 basis points is a, is a good, is a good delta.
Thank you. Your next question comes from the line of Ronald Kamdem of Morgan Stanley. Please go ahead.
Hey, congrats on the quarter. Just two quick ones from me. Just back to the debt extensions that you executed for 2024. Maybe is there a way to, to quantify once you annualize, what the, the, the interest cost delta is gonna be in 2024 versus 2023, now that you've extended those pieces? How should we think about that?
John, you want to take that one?
Sure, I'll take that one as well. it is, it depends on what you're assuming, for 2024 acquisitions. but we do think that, that, you know, we, we do provide the 2023 number, but I mean, it'll between rate increases and the acquisitions, that if you assume that those are, are funded with debt, then, you know, I would say that they're, you know, it's likely going up about $15 million.
Helpful. Just digging into the, the, the acquisition question, you know, I sort of appreciate, I guess, the acquisition and, and the development spend going down, going down, those projects pushed. One, can you just provide a little bit more color? Was it just, you know, the costs were too prohibitive, or was there something else? We know why those projects got pushed. Just would love to hear a little bit more about that. Then on the acquisition front, maybe what? You know, what do you think is causing deals to be so hard to come by? Is it, are you getting outbid? Is this just not enough volumes? Just trying to figure out how you shake this tree.
Yeah
to get more deals, get more deals through. Thanks.
Yeah. Dev, you want to take the development, and I'll cover the deal, the deal side on the acquisition?
Sure. Hi, Ron. No, Ron, look, on the Redev delays, it's, there's basically four projects that were pushed from 2023 into 2024. The reason varies by project, but it comes down to one of several things. Either, A, entitlement delays, or B, material delays, or C, the need for the neighbor to delay the start. Like, for example, one of these projects was a Publix in the portfolio. They did not want the store to be closed during the holiday season. They pushed it into early 2024. It's a combination of factors. It has nothing to do with the kind of returns that we can achieve on these projects.
We still continue to believe that we can do $50 million-$60 million of this activity on an annual basis, on a go forward, and that these projects will deliver cash on cash returns of 9%-12% on average. It's a very attractive use of capital, given the risk reward of these activities.
Does that, Ron, does that answer your question on the, the Redev stuff? Well, we'll...
Give me one second. I'm on mute, sorry.
Yeah. Ron, on the acquisition side, I think the difficulty in the transaction volume side, it's not anything really kind of out of the normal when you have a sort of repricing going on in the marketplace, and sellers are hesitant to sell at the new pricing, and buyers are hesitant to you know, they think the pricing change is going to be wider. We're really just going through that process, which is a very. I mean, it's, it's, it's happened a bunch of times in the past, and it will happen a bunch more. We're really in that process.
It's, and I don't think it's anything more than, you know, when interest rates go up and the cost of capital goes up, you know, pricing is going to expand. You're going to, you know, you're going to be in a market where you, as an owner, you have to adjust to the new pricing, and as a buyer, you're thinking it should change more. That's, that's the fight, that's sort of the battle that's going on. As we talked about, you know, that's probably led to somewhere between 50 and 100 basis points difference in spread. As, as you know, we've moved our targeted unlevered IRR from 8% to 9%.
That, you know, as we go through that process, it'll take time, but it, you know, it, it, as, as I said, it, it has changed probably a little quicker than we thought it would. You know, we thought we would be in a, you know, it would be a slower progress than what we're seeing right now, and, and hopefully that will allow us to, to meet and exceed our, you know, what, what our expectations are for the year on the acquisition side.
Thanks so much.
Yeah. Thanks, Ron.
Your next question comes from the line of Juan Sanabria of BMO Capital Markets. Please go ahead.
Hi, thanks for the time. Just a question on the balance sheet. You guys have done a good job taking leverage down over time. How should we think about you funding future acquisitions? Is the intention to lever up or to fund it kind of with an equity debt mix to keep leverage closer to where it is today?
Yeah.
Then as part of that, John mentioned reducing the floating rate exposure. Just curious on what the options there are. Thanks.
Okay. John, why don't I, I, I will talk a little bit about the first part of the question, if you can, talk a little bit about the, you know, what we're thinking about, in terms of, fixing some of the, the, the debt. Juan, as, as you know, we're, we're very focused on matching, our cost of capital with our acquisitions. So you can expect that, that, you know, we, we, we have a unlevered balance sheet in order to be able to, acquire, you know, actively when the opportunities are right.
You know, that's the discipline that we have, you know, shown this year and, and will continue to show going forward, that we will use the, the balance sheet to do that, but only when we can get into a market where, you know, we're getting, you know, accretive, with solid growth, properties that we can, you know, that we can use our, our, our machine to, to, to create a lot of, of value in. That's, that's sort of a long-winded way of, of saying that, you know, we will be looking at, the debt markets and, you know, and at the right time, where, you know, where, where, where the, the equity markets are, favorable.
You know, as you know, we tapped our ATM last year, at a time where we thought we were getting a really good spread between our cost of capital and what we were buying, and we thought that was an appropriate thing to do at the time. So we're always looking at that, and keeping trying to keep that balance between the two. John, you want to talk a little bit about our strategy on fixing rates?
Hey, Jeff.
Sure, sure.
Before we move on to John on fixing rates, I just want to remind Juan that, Juan, we generate over $100 million a year in free cash flow after the dividend, and we can acquire $250 million a year in assets with that free cash flow. The funding need for us kicks in when we exceed $250 million a year in acquisition. Then, as you know, our balance sheet is now 5.2 times debt to EBITDA, so we do have leverage capacity. So increments to that 250, we would typically take advantage of our leverage capacity to acquire that increment.
Yeah, I'll say.
Sure
The 250 that, that Devin's referencing is really to say that we can buy 250 without increasing leverage, and then increasing, we have a, a long-term leverage target of, approximately 6 x. In this environment, you know, we're- we are, are utilizing our, our low leverage and think this is a, a place to be. Given the opportunities, I think to Devin's point, we would definitely increase that. With regards to the floating versus fixed, yes, we are floating more right now. As we look at, you know, we have about $168 million on the line at the end of the quarter, great liquidity.
What the term loan financing really does for us is it gives us flexibility in this time frame where, you know, we can discuss whether or not the treasuries are, are, you know, higher or lower or where they're going from here. Also the, the spreads in those markets do seem elevated because of that uncertainty. What the term loans do is it gives us flexibility of time to get to a more opportunistic debt capital market. We think about that as we're thinking about fixed instruments. You know, the, the term loan allowed us to do that. We have an $800 million revolver available to us. We do have a long-term, you know, goal of being less than 10% fixed. I'm sorry, less than 10% floating. Sorry, less than 10% floating.
So as I'm thinking about it, if as we buy our, you know, our acquisition target for the year, and we move forward with a fixed instrument to fund that, that will help us move towards that 10% target, and hopefully then with a longer-term goal, getting even closer to where our peers are, which are in the 90s on a fixed basis. Again, a long-winded way, but, but thinking about it as in terms of the financing opportunity and where we are right now.
Thanks. Then just one last follow-up. bad debt, you reduced the, the guidance there. Seems like you're maybe running towards the low end of that of revised range. Just curious on the assumptions behind the, the high and low end of, of the bad debt range and kind of what's built in there. Is there an assumed degradation of the economy and at, at the lower end of the weaker end of the range? We're just curious on, on that range. Thanks.
Yeah. John, John, you want to take that?
Historically, this portfolio has been between 16 and 80 basis points of revenue over a long period of time. We are trending lower given the strength of the consumer and our neighbors. You know, as we look to the second half of this year, we, we do think that there is, you know, continued strength. I would say that it's in the middle of that. You know, I don't-- we're not forecasting quite as positive as it was in the first half. In terms of disruption that we would do, I, I would say that's probably less taken into account in the bad debt number because it's a pretty tight number there. I would say it's more considered in the, in the, in the FFO range that we provide.
Based on everything that we're seeing, whether it be retention, leasing, collections, we're not seeing any signs of deterioration. We're very positive on the second half of the year.
Thanks, guys.
Thanks, Will.
Your next question comes from the line of Mike Mueller of JP Morgan. Please go ahead.
Oh, hey. My question was answered. Tried to get out of the queue. Thank you, though. Great. Thanks, Mike.
Your next question comes from the line of Haendel St. Juste of Mizuho. Please go ahead.
Hi, this is Ravi Vaidya on the line for Haendel. Hope you guys are doing well. Just wanted to ask here, with the portfolio nearly full and minimal bankruptcies and watch lists coming, and now limited acquisition volumes going forward, where do you think the incremental source of growth is, will be coming from? Do you think you'll be able to continue to push renewal rents and similar spreads going forward? What do you estimate the current mark-to-market opportunity is within your portfolio?
Ravi, thank, thanks for the question. As you know, we, you know, there, there are two pillars for our growth. There's the internal growth that we get, and that's coming from the ability to, to, to really grow our, our rental stream through both contractual rent bumps, but also through, you know, getting strong releasing spreads on those and, you know, trying to minimize our, our capital while we're doing that, with a really strong retention rate. I, I think that internal engine will be less driven by occupancy increases and more driven by the pricing power we have to really grow rents. You can see that in, in our numbers, that, that, that we, we, we believe that will be ongoing.
We still think we've got, you know, anywhere from 50 to 150 basis points of increased small store occupancy to go, we're working hard at getting that to go. On a longer-term basis, we think that those engines will be there. Then we also have, you know, the readout stuff we're doing, which is obviously very accretive and work has been very positive in adding to the growth. Then, you know, we've got a strong balance sheet, which allows us to have the external growth. You know, when you combine those things, you know, we believe we can grow our, you know, core FFO on an annual basis in that, you know, mid to high single digit range.
You know, the, the, the operating environment and, and as some of the points Devin made in, in his prepared remarks, you know, we, we, we have some tailwinds that are allowing us to really see very solid growth there. I would, you know, we're, we're, we're very optimistic about our ability to continue to do that. We really, you know, one thing we want to make sure we emphasize to everyone is that, you know, we're, we're not seeing any cracks. I mean, it's not like we're, you know, we're, we're thinking that, you know, there, there's, there's a huge storm, you know, happening and, and we're, and we're just getting into it. That doesn't appear to be happening in the, in the market as we see it today.
I don't know, Devin, if you want to add anything there that I missed, but.
I mean, Jeff, what I would say, Ravi, we think that this portfolio on a go forward can generate same-store NOI growth of 3% to 4%. We realize that the growth that we've been getting in that same-store NOI number from occupancy is going to go down. We're getting closer to an occupancy level where it will no longer contribute to same-store NOI growth. That will be replaced by the growth we will get from new and renewal spread, which in the second quarter was 150 basis points of our NOI growth. Over time, we think that'll be 100-125 basis points. Contractual rent increases will contribute 75-100 basis points. Lastly, Redev will contribute 75-125 basis points.
Even without the growth in same-store NOI created by occupancy uplift, we still get to that 3%-4% same-store number with those other three elements of growth.
Thank you for that. Thank you for providing that bridge. very helpful. Just one more here. Do you have any update with the Albertsons Kroger merger, and any update regarding the potential store closure impact?
You know, we don't really have anything I would say as an update. You know, we continue to feel, you know, that it would be a really positive thing for us. We don't really see any, any downside in, in either of the options that are, you know, could happen. You know, we continue to watch the Albertsons stock as a, you know, a metric of where, you know, what the market thinks are, is the chances of it happening. Still trading at a 20% discount to the strike price in the merger. There's still obviously a lot of uncertainty around it.
You know, you, you get bits and pieces, but nothing that we've seen throws us to say, you know, one way or the other, that it's, it's, it's, you know, highly likely or less highly likely. It, it feels, and, and, and I think we're hearing that from management, that it's, it's taking its normal course, which doesn't mean it's absolutely going to happen or not going to happen, but it is, it is going through a very normal process for, you know, looking at these kind of, you know, sizable mergers in a, in a environment where it's, you know, the, the, there is a real big pushback from the government. Now, the government lost a big case this week with Microsoft, so they, you, you can see that it's not an all-win thing for the government.
There is a, you know, I believe that both Kroger and Albertsons believe that it is going to go through. I mean, I and they certainly are continuing to say that.
Hey, Jeff, on Ravi's question regarding closures, Ravi, what we've been advised is that in order for the merger to be approved, there will not be store closings that occur as part of the merger, generally, and then specifically to the PECO portfolio, we're confident that there would be no store closures in our portfolio, because as we look at the productivity of these banners in our portfolio from a sales per foot and the health ratio, they are viable grocery locations. So we're confident that there will not be any closures in the PECO portfolio as a result of that merger.
Thank you very much. Appreciate it.
Yeah. Thanks, Ravi.
Your next question comes from the line of Todd Thomas of KeyBanc Capital Markets. Please go ahead.
Hi, thanks. two questions. First, I, I just wanted to clarify quickly, Jeff, your comments about asset pricing. You mentioned 50-100 basis points. I, I think I also heard 150 basis points in response to a question. Were you speaking to cap rate expansion or the, the spread that you require for new investments versus your cost of capital or, or something else entirely? Can you just clarify, you know, what you were speaking to?
I guess I was-
between the two.
I guess I was... Yeah, I guess I was clear as mud, right? Not, sorry about that. The, the, what, what I was talking about 50 to 100 basis points was the increase in the cap rate. The 100 basis points was the increase in the unlevered IRR that PECO, you know, has done to our, our underwriting as we look at, at new opportunities. Those were, I think, the two numbers. I don't know what the hundred-- what I said about the 150, because I, I don't know where that, where, where that would have come from, but we did add 100 basis point to our unlevered IRR and believe that there's 50 to 100 basis point increase in the cap rates.
Okay, got it. Are, and are you still seeing cap rates expand a bit, you know, today or, or, you know, have they, you know, stabilized a bit more recently?
I, I, I would say that the, the, we, we, we believe that there probably is some more expansion in the cap rates, but it's, it's minor compared to what, what's happened so far in, in our opinion. Now, you know, if, if, if rates stay higher for longer, that, that could change. Our, our belief is that we've, we've seen the major change. From here, it will be more adjustments than it will be any kind of major change in, in cap rates.
And then you, you talked about the high retention across the portfolio, almost 94% again this quarter. Do you expect that to hold in 2024? You know, particularly, you know, with regard to the 71 anchor lease expirations, you know, any, any thoughts there or any early indications on, on what you might expect, you know, around the anchor expirations specifically?
I don't know if Devin or John, you want to take that one on those specifics.
Yeah. I mean, I would just say, Todd, in terms of retention, we have seen fairly consistent retention rates over the last year. You know, varying from a low of 89%, you know, to a high of 95%. So, you know, the 94% is at the higher end of the range, but, you know, we believe that our retention rates are going to be fairly stable, because we continue to see very strong retailer demand for our product type. So we're not expecting to see a material move in that retention rate relative to what we've seen historically. Then on, that was an overall retention rate, Todd, then on the anchors, you know, it's, it's, varied between a low of, you know, 98.7%, and a high of 100%.
You know, again, it's between 99% and 100%, so we're pretty confident that that rate will be consistent in, on a go forward. Again, given the productivity that we're seeing out of our anchors and the kind of health ratios that we're seeing from them, the combination of those factors lead us to be confident that, you know, they will all exercise renewals or options that they may have.
Okay. And then, lastly, there, there was an article out this morning, discussing Amazon and their, their, you know, growth, growth from them in grocery. You know, I know they've tested various formats, but growth in their, their grocery footprint's been, been somewhat limited, maybe a little unclear over the last few years. Just curious, you know, any thoughts on the potential for them to expand their footprint, what that might look like, and how that could impact the, the grocery landscape and maybe your portfolio specifically as, as you think about that potential expansion?
Yeah. So Todd, I- it's, it's a great question. It's one that we actually looked at, have looked at consistently since they opened their first new grocery concept. They, they have a lot of work to do. I mean, they, they've got to prove that. I mean, you never underestimate Amazon. I, I, I, I take that as a given. On the grocery side, they, they have not been able to really find a differentiated strategy that allows them to be a lot more productive than a traditional grocery store.
You know, it's nice to have a new store and all that, but when you go into their stores, they, they just are very similar and with, with very little sort of anything you'd see, you'd say, "Wow, this is, you know, is, is really going to, you know, get every customer to want to be there." They're, you know, they, they've got a lot of work to prove that they actually can develop a, you know, a, a format that the consumer is willing to, you know, say, "Look, I'm, I'm not going to go to my Kroger anymore. I'm going to go to Amazon." So far, they haven't been able to do that. Until they do that, you know, they're, they're really not a, a serious threat to, in, in a, in any kind of scale.
They, and they certainly aren't going to scale it at the, at the current format, because the current format is not making money. It's not only not making money, I mean, I, I, you know, we're, we're, we're hearing sales numbers that are, you know, very mediocre. They-- I mean, they've got to find something where they can really differentiate themselves, and to date, they haven't been able to do that. Until they do that, we're, we're going to keep-- You always watch Amazon because, you know, they, they can do a lot of stuff. I mean, there have been rumors that they were going to buy a bunch of the overlapping Kroger Albertsons deals. I mean, there, there, there have been rumors forever about them.
They don't seem to be opening the stores that they've got obligations to open up even. They're, they're in a, they, they've got a lot of work to do to prove they can, you know, they can successfully get into that, into that market.
Okay. All right. Thank you.
Yeah. Thanks, Todd.
Your next question comes from line of Dori Kesten of Wells Fargo. Please go ahead.
Thanks. Good morning. When, when you look at your watch list, I know it's relatively small at this point, but, would you imagine your 2024 bad debt looks close to your long-term average, you said the, the 60-80 basis points?
Yeah. Dori, we, we do believe that it will. I mean, that's what we are projecting. We don't see anything there that, you know, obviously we don't. As you know, we don't have a lot of big box exposure, so our, you know, our exposures to any particular brand other than our grocers is very limited. So, you know, we and we don't see anything there that would push us outside of sort of a normal category. You know, obviously, you have a major recession, and then, you see what happens.
As you know, I mean, we, we did- we've done really well in the last two recessions on a relative basis, losing, you know, the, the, I think the least in terms of occupancy of, of anybody in our space. Again, that's the focus on necessity-based goods and, and our grocer focus.
Right. Okay, thank you.
Yeah, thanks, Barry.
Your next question comes from line of Floris van Dijkum of Compass Point. Please go ahead.
Hey, guys, thanks for taking my question. You guys continue to amaze me because I think your anchor occupancy, I, I believe, is the highest in the sector. I don't know how many you know, empty boxes you have in your portfolio, but it's got to be a handful, less than a handful. Your shop occupancy, I think, is also the highest in the, in the sector. You know, obviously, that, that impacts your ability to, to grow occupancy, particularly on the anchor side. But maybe if you can give us a, how much more can you push shop occupancy, in your opinion, realistically? Then the, the follow-up on that is, you know, the, the, the underlying fundamentals certainly appear very positive for retail right now. There's, there's almost no new supply.
As you know, Jeff, you know, the, the, the landscape evolves continually.
Yeah
how much more do you think rents need to rise in your markets in order for new construction to be justified?
Floris, thanks for calling for your question. Deb, you want to take the occupancy growth, and, and then I'll, I'll talk about the, you know, what we think sort of the, the, the, the retail opportunity is on, on the growth side for new development.
Sure. Floris, we continue to surprise you because you to underestimate us, our hope is continue to surprise you. In terms of small shop occupancy, we think we have another, as Jeff said, 50 to 150 basis points of occupancy uptick there. We realize that that then impacts our same store NOI growth, which we continue to believe will be 3%-4% going forward. The loss of same store NOI growth created by occupancy will be replaced by our ability to continue to push rents. We think the components of our same store NOI growth going forward are new and renewal spreads at 100 to 125 basis points. In the second quarter, that metric was 150 basis points.
Contractual rent increases of 75-100 basis points of growth, then the contribution of our Redev activity at 75-125 basis points, which gets you to that 3%-4% same store metric. Again, we continue to believe that these growth profiles are reasonable on a go forward because as we look at the marketplace, if you look at the centers we acquired in Q1, we paid on average $220 a sq ft for those assets. We think replacement costs for those assets is circa $425 a sq ft. Rents would need to almost double in order for new development to generate an acceptable return on investment.
You know, our view of, of this market is there's been limited supply over the last 10 years, and there will not be incremental supply on a go forward until we see rents move meaningfully from where they are today.
Yeah. and Floris, just to add to that, you know, there, there are specific markets where some of the regional grocers are expanding. You look at Hy-Vee, you look at Publix, you look at H-E-B, they, they are doing some new stores in very specific markets. it's, it's, it's those areas that you've got to be cautious about in terms of where, where, where that competition is coming in, because as you know more than anybody, like, we, we compete in a 3 mi radius around our centers, and each one is its own market with its own competition, and we have to win it. You got to win it though, in those levels. development is, is, is not happening in the vast majority of the, of the markets we're in, and.
We're always, you know, we're always watching because, you know, you don't, you know, it, it is very specific to the specific stores that, you know, where, where, where we have locations. One of the things that we, you know, we, we look at is, you know, the, the, the, the rents that you need to get for new development. You know, if you look at some of the, the more urban and major, major markets, you know, the rents are closer to where you could actually do development than, you know, some of the markets where we're in. You know, that, that will, you know, the, the first new development, as you see it, it, it happen, is more likely to happen in those markets than it is to happen in the, in, you know, the markets that we're in.
I mean, it's you're, you're, you're not gonna see that happening. We, we believe in, you know, Atlanta and, and Tampa and, and Orlando, where we, where we where our centers are, you're more likely to see it in, in more denser urban areas where they can, you know, they can get the kind of rents that justify new construction.
Thanks. Maybe just the, the, my follow-up is, is I noticed your, your NOI margins dropped marginally, you know, in during the quarter. Obviously, they were relatively, you know, consistent through the first six months, anything that you can-- is it, is it, you know, some expense growth or, or, you know, anything else? Is it, is this part of the, the, you know, previously uncollected rent that you got last year that caused that drop?
John, do you want to take that one?
Sure. Floris, we're talking about 30 basis points here.
I know...
72.4% in the quarter, 72% on the six months. I mean, I think, at that point, it's, it's really the 72% margin is, is where we, where we see it. I mean, expenses are, are gonna move, I mean, I think that's a good run rate and, and still very strong.
Yeah, that's it. Thanks, guys. By the way, that also isn't a testament to your, to, your ability to run your business.
Well, thank you, Floris. We appreciate it. Yeah.
Again, if you would like to ask a question, please press the star followed by one on your telephone keypad. This concludes our question and answer session. I would like to turn the call back to Jeff Edison. Jeff?
Well, first of all, thanks everybody for being on the call today. You know, we did have a really solid quarter. You know, when, when you're getting same-store NOI growth to 5.3%, when you're at record occupancy for your anchors, and your in-line stores, and you're seeing very little of any, and really no cracks in, in terms of our leasing ability, when you're able to purchase $80 million in the first, you know, half of a really tough year, and a, and a tough adjusting market. We, we were able to improve our balance sheet, increasing our debt to EBITDA, extending our loan maturities until 2025, and, and really on a material basis to 2027, giving us the flexibility that we want.
You know, we're gonna, we're gonna continue to drive, we think, strong results through 2023 and 2024, and we're gonna focus on really good internal and external growth. Again, thank you for being on the call today, and, and have a great day.
Thank you. This concludes today's call. You may now disconnect.