Hi, everybody. This is PECO's roundtable presentation. I'm Lizzie Doykan. I work with Jeff Spector in covering the retail REITs at BofA. With us today, we have Jeff Edison, CEO, Devin Murphy, President, and Curt Siegmeyer of Investor Relations at PECO. So I'm going to turn it over to the team to start with any opening remarks. Just kind of give us an overview of the state of the business today, maybe any operating updates, if you've come to the conference with this, and then we can open it up to Q&A. And please, you know, jump in at any time with any questions. So with that, I'll turn it over to Jeff.
Well, thank you, Lizzie, and thanks, everybody, for being here. It's standing room only. You can see with this huge audience. But we do thank you guys for being here. You know, we are in an environment today in our business where the operating side is as strong as it's been in a long time. We are at record occupancy levels. We're at record numbers. And we're in an environment that, you know, on the operating side is very strong. We feel that, like, this is not just a short-term, like, blip. This is an operating environment that is being driven by really a lack of new supply in our space for a sustained period of time.
That lack of new supply with strong retailer demand is allowing us to get, you know, really, you know, record levels in terms of occupancy and rent spreads. So we're very positive on the operating side. On the, you know, with what's happened in the interest rate market, the acquisition side is a little less stable or defined. We have seen the first half of this year a very muted level of acquisition opportunities. What was difficult for us was to be very disciplined in not buying anything during the first half, as the market was going to, you know, moving towards understanding where was pricing, you know, in this new interest rate environment.
We have seen some change in that market over the last 6-8 weeks. We've seen, I think, a number of projects that we feel really good about have coming to market, that we've been awarded, that we're, you know, excited about. And we think that so we think that the market is starting to show signs of accepting the new pricing rates, which are probably. You know, we at the, you know, end of last year came, and a little before that, changed our unlevered IRR target from 8% to 9%, just given the what was happening with interest rates. You know, that made it tougher to buy.
Part of the reason we had, you know, we had a slow acquisition pace during the first half of the year. The market's starting to get there on that and, you know, we're, we're optimistic. We told that at the end of earnings last year or last month or last quarter, we confirmed our target of $200 million-$300 million of acquisitions this year. We were, you know, we were pushing to get there. We're much more comfortable with those numbers today than we were even six weeks ago. So the market is moving. We feel positive about that. So we think our external engine of growth is there, as well as the internal engine that we talked about on the operating side.
So, I would say we're in a spot where we feel really good about those pieces of our business strategy. And, you know, when we came public, you know, we had a very targeted focus on grocery-anchor shopping centers. We continue to keep that focus, and we are optimistic that we're in a really good space to be able to show significant growth, and are excited about it.
Great. Thank you. I'd like to touch on the operating side first. So, in terms of organic growth, you know, can we discuss what you see as the building blocks for your long-term same-store NOI target of 3%-4%? You know, how high can you really take occupancy? You have some of the highest rates in the space, and can we continue to expect new leasing spreads in that 20%-30% range? If we could just go through the building blocks of that growth.
Sure. So, our view is we have a long-term, sustainable same-store NOI growth of 3%-4%. The building blocks of that are, we believe that we'll get 125, a 150 basis points, excuse me, of NOI growth from leasing spreads. We'll get 100 basis points from contractual rent bumps that are embedded in the existing leases. That gets you to 2.5%. And then the last component of that growth is, our redevelopment activity, which will deliver 125 basis points. So that gets you to the high end of that 3%-4% range, and that's assuming no contribution from occupancy growth. Now, we are almost 98% leased at the portfolio level. Inline is just under 95% leased. We think we can still take inline-...
another 100-200 basis points here. So that'll be another 100-125 basis point increase in same-store NOI in the near term, as we capture that occupancy uplift. And then obviously, you know, we think we're done. You know, the reason we're optimistic that the kind of spreads that we're enjoying. So in the second quarter, our inline re-leasing spreads were almost 18%, just under 18%. That has been trending upward for the last several years. Historically, in this business, we were getting 8%-10% re-leasing spreads in line. Last year, it was 14%. Second quarter, it was almost 18%. If that is continuing to improve, and there's a simple reason for that, which is the point Jeff made on supply. You know, we're seeing very little supply added in this business.
And if you look across the U.S., the occupancy level of open-air grocery-anchored retail is 94%. So there's very little inventory available for the retailers to lease. And then the demand from the retailers in terms of the kind of properties that we own, 100% suburban and 50% in the Sun Belt, is being driven by a number of macro trends. Suburbanization, the move to the suburbs, work from home, people spending more time in the suburbs, migration to the Sun Belt, and then shrinkage in the urban environments, is forcing the retailers to look more at the suburban markets for their growth. And so we're getting the benefit of that retailer demand that we've not seen historically.
Then in addition to just overall retailer demand being driven by those macro trends, there are emerging verticals in our portfolio that we call medical retail. We call it MedTail. And if you look at our portfolio over five years ago, we basically had no exposure to that tenant use. Today, it's high single digits of our, of our ABR. It's about 20% of our portfolio. So we see that demand cohort growing. So you know, this combination of limited supply, strong demand for the kind of assets that we own and operate makes us confident that we'll continue to be able to enjoy the kind of same-store NOI growth that we're currently delivering. And, you know, for this year, we think that number will be north of 4%.
You know, the midpoint of our guidance is north of 4%, which is again above the high end of the range that we believe is achievable on a long basis.
The only thing I would add there on the supply side is, you know, online was, you know, gonna grow to the sky. And, you know, the growth of online is significantly reduced. Online retail has significantly reduced. That was another threat to supply. And that is another part of the supply that is reduced, and almost everyone in the online-only business is looking for bricks and mortar as part of their strategy. Again, adding to the demand for space. So you've got this decreasing amount of supply of online retail sales, so that's actually part of what's helped the, you know, us to have the kind of operating environment we are in.
When it comes to your inline space, can you discuss, you know, the state of the health of your neighbors? How do we think about the 10% occupancy cost ratio there for the inline retailers going forward? And, you know, should we be concerned with any of the categories, because you have such low exposure to the more distressed categories that we're seeing?
Yeah. If you look historically, Lizzie, I know there's a perspective that 26% of our ABR comes from what we call local neighbors. So those are smaller operators that own less than three locations in their portfolio. However, they're highly successful entrepreneurs, they have strong credit, and they bring a uniqueness to the merchandise mix that we like. And if you look at our historical performance with that type of tenant, it's been very good. If you look at the amount of occupancy we lost during COVID, it was lower than any of our public peers, and we recovered our occupancy losses faster than any of our public peers. So again, we are very confident in the credit quality of our neighbors.
I think in terms of a perspective on the viability of us continuing to push rents at the level we're at, I mean, we would say, look at our renewal rate. In the second quarter, our renewal rate was 94%, and that's in the face of the kind of spreads we're getting. So our tenants are clearly believe that they can continue to pay the kind of rents that we're demanding and stay in this space. And if you look at that, retention rate over time, again, it's a positive trend line. So we're, we're pretty optimistic that, you know, credit is not a big concern for us, given our business model. If you look at the exposure that we had to Bed Bath & Beyond, in the aggregate, it was less than 50 basis points.
We don't have exposure of any meaningful level to any of the other retailers that are on people's watch lists. If you look at our watch list, our top 10 tenants on the watch list represent less than 2% of our ABR. And the one tenant on that, you know, people are particularly worried about is JOANN Fabrics. We have a de minimis amount of exposure to JOANN. It-
... sort of 30 basis points. So, we have very limited exposure to big box retailer, where distress has tended to occur, A. And then B, we're extremely well diversified. If you look outside of grocers, our single largest tenant, ex the grocer, is T.J. Maxx, and they're 140 basis points of our ABR. So, credit concern is definitely not on our top list of concerns.
Outside of the more watchlist tenants, you know, recently, Kroger and Albertsons did announce that they were going to sell off over 400 stores to C&S. So just wanted to gather your thoughts there. What, what is PECO's exposure and maybe the thoughts on, on the deal going through?
Great. Let me start with the deal going through. Right now, Albertsons is trading at about a 13% discount to strike price. So the market is saying they that that's up from a 20% discount that they have been trading. So the market is kind of saying that it's, the C&S announcement is helpful, but certainly does not give certainty. And J.P. Morgan came out this week, and their belief was that it was a 5% chance of happening, and now they think it's a 20% chance of happening. So it's whether or not the merger happens or not is still, you know, very, very questionable. Like, there's certainly a big risk that it does not happen.
We've looked at it from the very beginning when they first made the announcement. We have, you know, somewhere in the low 30s in terms of exposure centers where there's a sister store within three miles of an existing store that we have. And so that's our range of exposure. That's with—we have 93 across the Albertsons and Kroger banners in our store. We are Kroger's largest landlord, so we are, you know, we are engaged in this thought process of what could happen. The original plan when we had that 33 that now is 27 after the announcement, because of some of the positions they've taken and where they're gonna trade out stores.
So that's generally a positive, that there's less exposure. We think our real exposure is somewhere between five and eight stores that could stay under the C&S banner or move under the C&S banner versus the Kroger or Albertsons banner. They will use the banners. The part of the deal is that C&S will take the banners over that Safeway and Albertsons had. So there is a place that they will probably be operating as those stores. Which we think is a significant improvement from PropCo, which was their last plan, which... And PropCo was gonna be, they were gonna take all these stores, they're gonna put them in a pool, and PropCo was going to be run by some kind of company put together of Albertsons employees.
That—so this is a significant improvement from that. C&S, who is the buying partner, it's a 100-year-old company. They're the largest wholesaler in the country, so they're a real grocery operator. But they've been on the wholesale side more than they've been on the operating side. So that's, I think, the question out there for the 5-7 properties that might go under that banner. But as we say that, the other properties that we've got that are under that banner, which, you know, if we say it, it's 10 at the sort of the high end of the range, you know, you've got 83 properties that are now worth more because you've got, one, you've got a stronger grocer running them.
The Albertsons, which is, I think thirty-
Thirty-one.
31 of those stores, they're now not run by a private equity firm-
Mm-hmm.
But they're run by one of the best operators in the world, or certainly in the country, in Kroger. So we're gonna see significant improvement in those, the running of those stores. So that generally is the reason that we're positive about the transaction, even though we do still are recognizing that it still has a fairly low probability of getting through the FTC without some significant changes.
Turning to external growth. In the beginning, you did comment, you know, you all are seeing some signs of new pricing, some activity, and you reaffirmed $200 million-$300 million of acquisitions this year. That's, that's pretty in line with last year. Are, are you seeing, just to clarify, changes in pricing? If you can kind of, you know, give us a gauge of what you're seeing out in the market today. We know you did close on a, on Lake Pointe Market.
Yes.
So, what would you need to see in the market to get additional deals done in the second half?
So, as interest rates started to rise, we made the decision to change our targeted unlevered IRR from an 8 to a 9. We think that that gives you some measure of the increase in the cost of capital, given the dramatic increases in interest rates. So, the hurdle for us, for the first half of the year and going forward, is finding opportunities where we can get to that level of unlevered IRR and, given our sort of strict underwriting that we do, which basically does not assume any kind of cap rate compression or, you know, excessive kind of assumptions. So we feel really good about our underwriting.
We feel like, but getting to a nine is not an easy thing for grocery-anchored shopping centers, and particularly with the number one or two grocer in it, doing really good sales. So we have to hunt pretty hard. And I would say that our feeling is that pricing has moved from sort of a mid-5s cap rate to well, we've moved 100 basis points in our IRR, and really our IRR buyers, that always translates into a cap rate. But that changes the cap rates from 5.5 to 6.25 to 6.5. And so that's the movement we've seen.
You know, that movement gives us. I mean, as the market accepts that movement, because there are a lot of sellers who have not accepted that change. That's gonna, you know, that will be the sort of governor in terms of how much we can buy. How much the market really accepts that change.
Yeah, if you look at the five assets we've closed on year to date, it's circa $92 million of acquisition volume, and the weighted average cap rate was a 6.3%, which is pretty consistent with what the cap rate was on the acquisitions we accomplished in 2022. So we think the cap rate movement occurred pre-January of this year, because interest rates started moving up in February of last year. Cap rate movement really occurred back half of last year, and it's basically moderated and basically stabilized. What we're seeing is more supply coming into the market right now. The point Jeff was making, sellers have begun to accept the fact that this asset back in 2021 was a 5.5% cap asset, is no longer a 5.5% cap asset, it's now a 6.25% cap asset.
And given where rates seem to have stabilized, and the fact that this is not a temporary movement in cap rates, they're like, "This is an asset we want to sell." So they're fundamentally capitulating, if you will, that, you know, asset pricing has moved to where it's moved. We're accepting of that reality, and therefore we're going to transact on the asset.
On Lake Pointe Market specifically, so that's a grocery-anchored center that PECO acquired post-quarter.
Yeah.
What pricing did that close at, and is that reflective of the conditions you're speaking to?
It traded slightly higher because it was a shadow-anchored asset, not we didn't get the revenue from the Albertsons that was there. And so it traded in the, I think it was in the seven, in the, like, the low seven cap rate. But it had an unlevered IRR well above nine. It was in the 10 kind of range. So we I mean, I think there is, there's always a little trade-off in these deals back and forth. But so I would say seven is ... We got compensated for the shadow-anchored part of it.
With the shadow anchor would've been a 6-6.3, kind of the yield to get to the returns that we were talking about.
Just on that topic, you know, we're seeing a lot more public-to-public consolidation within the strip space. It's probably the most topical thing right now. You know, what are your thoughts on Kimco's with RPT and, did that make the PECO team, you know, change your approach in terms of discipline, in terms of quality, and what is out there? You know, one of your peers had commented that we're actually seeing more of a limitation on public to public. So, you know, do you think we'll see more of this? Just general thoughts.
Yeah. So, having done this for a long time, we've bought a number of portfolios over time, and the complication with portfolios is you don't get what you want. And so we have been, pretty disciplined, not very disciplined actually, in buying individual assets versus buying portfolios. Because as an example, when we looked at RPT, you know, we, we would have had to sell off 75%-80% of the properties, because there was only a small part that actually met what we, we do in the, in the grocery- anchored, right size, grocery- anchored shopping center with the number one or two grocers. So it's, a very different play for us.
You know, Kimco is in the power business, so they fit with them, you know, much better than they would fit with our strategy. And we're, you know, we look at basically everything that comes into the market. But I would say that the chances of us getting to one of those larger transactions, it would be difficult, because it's, you know, we are very particular about what properties we want in our portfolio. And when we buy them individually, we just feel more comfortable that we've done the underwriting. We know we're getting what we're getting.
We're not, you know, compromising on what we buy, and that it's worked for us for a long time, and we think that that does build the strongest long-term portfolio. But I say that, and yes, there we will look at those transactions at the right, you know, right price and right timing. But I wouldn't count on us being one of the, you know, real active in that part of the market.
I mean, Lizzie, we have a cost of capital that would allow us to be a buyer in a public merger. But to Jeff's point, we have a unique business strategy, and there are very few public companies that have a business strategy that aligns with us. So there are not a lot of potential merger candidates for us in the public market. So that's why it's, it's we're unlikely to be an acquirer that way. The thing that we think may be underappreciated is, there are 5,800 shopping centers in the U.S. that are anchored by the one or two grocer in the market, and have the demos that we're looking for when we acquire an asset. So the buyer, the buying pool that we can access is deep. And there's a lot of assets that we can acquire that meet our objectives.
And, you know, we believe we'll get a better return on an asset-by-asset acquisition strategy than we will if we migrate to a corporate or portfolio acquisition strategy. And, you know, we think that given how lowly levered our balance sheet is, at now circa 5x debt to EBITDA, we have plenty of dry powder to acquire. And if the market shows us assets that allow us to hit our 9 on lever, you know, we could buy $500 million-$600 million of assets, which as a percentage of our market cap would be meaningful.
Yeah.
We're confident we can grow the company at a very attractive level on an asset-by-asset basis.
I guess turning to the balance sheet then. So, you know, you recently... You extended the maturities on the $475 million of term loans, and now you have no meaningful maturities until 2027. But those underlying swaps on the 2024 maturities will expire-- or they will expire in 2024. So how are you going to address, you know, those swaps when they roll off?
Yeah. So our view is that our target on floating rate debt is approximately 10%. We recognize that we're currently above that level. Our view of the debt markets right now is that spreads are at historically wide levels, given the uncertainty in the underlying index. Investors don't know where the index is going, so they're demanding wider spread on leverage. So we will have to do a fixed rate financing in the next 12 months, Lizzie, to take our floating rate debt down to our targeted levels, which we expect to do. Our hope is that we will see spreads grind in a little bit here as there's more perspective on where the index is going, and therefore, we'll be able to finance at a more attractive rate.
And then when it comes to earnings growth, so you mentioned you can produce mid- to high-single-digit FFO growth beyond 2023. You know, if you could speak more to the pieces of getting to that growth-
Sure.
-maybe-
So-
going off of how this year will end, yeah, and without giving hints into next year, you know, how, how we should see that progress?
Well, the issue that we and a lot of REITs have is the incremental increase in interest rates. If you look at what the cost of debt for us in 2023 is, as a metric, it's $0.14. So it's basically a 7% headwind in growth. Despite that 7% headwind in growth, we'll still put up positive FFO growth in the low single digits in 2023 with that headwind. That headwind is going to moderate in 2024 and 2025, and then ultimately go away. So our view is that mid- to high-single-digit is a longer term run rate. It will be less than that in the near term, given that that debt headwind. But the components of it are 3-4% NOI growth. With operating leverage, that translates into circa 5.5% growth internal.
And then we add to that, the growth we can get from acquisitions, the external growth. So that's, those are the building blocks of the growth profile.
If we go back to, you know, acquisition targets, how does PECO really define quality? And I know it's going to differ by REIT, but how do you define that?
Everything is A-plus quality.
Yeah. I mean, you often talk about the SOAR method in approaching, you know, what makes sense for your portfolio. So given there's so much opportunity out there, how does it—what does it really come down to?
Yeah. So I think the simplest way to think about it is, if you don't live in New York and you live in the burbs, you're on a Saturday, when you wake up and you've got to do your necessity-based thing. I gotta go to the grocery. I gotta get my nails done. I gotta get my hair cut. I gotta I wanna work out. I wanna get a smoothie. Where do you go? And what the average American does is they go to their Kroger. They actually go, and they do their other things first, and then they end up at their Kroger, and they come home with having done that. And they do that within three miles of their house.
What we try and do is provide the best shopping center with that number one or two grocer close to your home. And that is a very different shopping experience than when you go to Home Depot for your home project, or when you go to, you know, get a big screen TV. Like, those, that's a different shopping experience. Our focus is on that necessity-based focus of three miles from your house with the right grocer that will, you'll go to on average 1.7 times a week. That, that's, that's our strategy, that, that's been our focus. And, you know, we, we think that that is, what differentiates us and is what's been able to produce the results that we've, we've been able to produce.
And we view quality as where do retailers want to lease space? Because at the end of the day, they're the customer, and where the customer wants to be should define quality. And as we look at our portfolio, we have 98% occupancy, highest in the business. We have a 94% retention rate among our neighbors, tenants. We call tenants, neighbors. So in our view, the customer is giving us an A+ on the quality of the assets that we own, because we have the highest level of occupancy, we have the highest level of retention. So our customers are extremely pleased with the product that we're delivering, which we would view as being high quality.
Yeah.
Just turning to supply now, because this is now we're seeing the space just marked by years of, you know, supply being at its lowest.
Yeah.
When do you believe development of new shopping centers might start? And can you just characterize, like, what you're seeing in your own markets today?
Sure. I'll, I'll move them both.
Yeah.
So if you look at what we bought first half the year, we bought it at $225, but that's what it costs, all in, including the land. To replace that is probably $450. Rents, in our mind, to justify new development, new supply, would have to almost double to what they are today in order to justify the risk of new development. So our feeling is that the supply side is, it's a ways from starting. It's certainly. We know that it's not happening right now, which means at the earliest, it's 2-3 years out.
If somebody tries to start a development project today that we would know about, because we would know the anchor and where they were going, and that's easily a 2, but probably a 3 year before they're actually a competitor of yours. And we're not seeing any of that right now. So you look at it and you say, "You know, we do have a decent runway." And that, you know, we feel pretty good about that.
All right. Anything I missed? Any questions out in the audience?
What's the, what's the competition like from the grocery-anchor? Obviously, you guys have proven your model right really, really well. Are interest rates keeping buyers away? Is it less competitive, more competitive, than the last three years?
Yeah. Great, great question. I would say that some parts are stronger and some parts are weaker. grocery-anchor shopping centers have become more popular. I mean, we've been doing it for 30 years, so we're not new into the business, and we've seen the cycles go up and down for grocery-anchored shopping centers. There is more interest in grocery-anchored shopping centers today than there was 3 years ago. So I would say that that is a, you know, it brings more competitors into it. The leveraged buyer used to be a fairly significant player in our market, as well as the tax-free exchange buyer. Both of those are very muted right now.
I mean, if you're having to borrow a significant amount of money, I mean, a lot of that they borrowed was from the regional banks, who are pulling back dramatically in terms of their allocation to new loans for buyers. So that part is less, the leveraged buyer is less. The institutional buyer is probably the same, maybe even a little bit more, but they're but it's early days for them. They're concerned. They're not comfortable with where the pricing is. They don't know where it's going to end up, so they're not. We're not seeing them show up. We anticipate them showing up, and there's certainly conversations about them showing up. And those are our two biggest competitors when we're buying properties.
So one side's really gone away, that tax-free exchange and the leveraged buyer, but the institution buyers are there, and on specific assets, they're, you know, they will pay a lot, you know, they're willing to pay a lot more than we will for certain properties.
All right, so we're actually out of time.
Yeah.
Before we end, I'd like to end with three rapid-fire questions.
Mm-hmm.
No long answers. So first question on the Fed: Do you believe the Fed is done hiking, yes or no? Do you expect the Fed to cut rates in 2024, yes or no?
No and no.
Right. Number two, do you believe real estate transactions will meaningfully pick up by the fourth quarter of 2023, the first half of 2024, or the second half of 2024?
First half of 2024.
Meaningfully, yes.
Last, are you using AI today to help you run your business, yes or no? Do you plan to ramp up spending on AI over the next year, yes or no?
Yes and yes.
All right. Thank you very much.
Thanks, Lizzie.
Yeah. Thanks, Lizzie.
Thanks, everybody.
Yeah. Thanks, guys. Thanks, everyone.