Essential Properties Realty Trust, Inc. (EPRT) Q4 2022 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Essential Properties Realty Trust Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] This conference call is being recorded and a replay of the call will be available two hours after the completion of the call for the next two weeks. The dial-in details for the replay can be found in yesterday's press release. Additionally, there will be an audio webcast available on Essential Properties website at www.essentialproperties.com. An archive of which will be available for 90-days. It is now my pleasure to turn the call over to Dan Donlan, Senior Vice President and Head of Capital Markets and Portfolio Management at Essential Properties.

Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties fourth quarter 2022 conference call. Here with me today to discuss our operating results are Pete Mavoides, our President and CEO and Mark Patten, our CFO. During this conference call, we will make certain statements that may be considered forward-looking statements on our 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 those forward-looking statements to reflect changes after the statements were made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the Company's filings with the SEC and in yesterday's earnings release. With that, Pete, please go ahead.

Thank you, Dan, and thank you to everyone who is joining us today for your interest in Essential Properties. We finished 2022 on a strong note with a record $328 million of investments in the fourth quarter and $937 million invested for the full-year. This translated to year-over-year AFFO per share growth of 14% in 2022, which we are extremely proud of given the unprecedented volatility in the capital markets and the rapid raise in interest rates. As our fourth quarter results indicate, our portfolio continues to perform at a high level with unit level coverage of 4x, occupancy of 99.9%, and same-store rent growth of 1.6%, which speaks to the de minimis credit losses that we experienced in 2022 as our weighted average contractual rent escalations are approximately 1.6% per annum. This strong performance is a testament to our granular and fungible properties, the resiliency of our service oriented and experience-based tenancy, which represents 93% of our ABR and our proven ability to accretively recycle out of our weaker performing properties. On the investment front, we remained active in support of our long-standing tenant relationships, as they are increasingly turning to us as a reliable capital provider to grow their footprints given the limited funding available in the bank market and private leverage buyers largely being sidelined due to the dislocation in the debt markets. With quarter-end pro forma leverage of 4.5x and liquidity of nearly $700 million, our balance sheet continues to be well capitalized for our investment activity. We are reaffirming our 2023 AFFO per share guidance of $1.58 to $1.64, which implies year-over-year growth of 5% at midpoint. Turning to the portfolio. We ended the quarter with investments in 1,653 properties that were 99.9% leased to 350 tenants operating in 16 industries. Our weighted average lease terms stood at 13.9 years with only 6.1% of our ABR expiring through 2027. From a tenant health perspective, our weighted average unit level coverage ratio was 4x this quarter, which was expected given the lagging impact of inflationary pressures flowing through our tenant financials. Our percentage of ABR under 1x coverage continue to moderate from pandemic pressures experienced during the reporting period, and now stands at a more normalized level of 3% of ABR. During the fourth quarter, we invested $328 million through 39 separate transactions at a weighted average cash yield of 7.5%, which was up 40 basis points versus the prior quarter. These investments were made in 13 different industries with 75% of our activity coming from the carwash, casual dining, auto service, and entertainment industry. The weighted average lease term of our investments this quarter was 18.7 years. The weighted average annual rent escalation was 1.8%. The weighted average unit level coverage was 3.2x and the average investment per property was $2.8 million. Consistent with our investment strategy, 99% of our quarterly investments were originated through direct sale leasebacks, which are subject to our lease form with ongoing financial reporting requirements, 90% contained master lease provisions and 95% were generated from existing relationships. Looking ahead first quarter of 2023, we have closed $65.7 million of investments to date at a 7.6 cash yield. Our investment pipeline remains robust as an increasing number of middle market companies are seeking sale leaseback capital as a financing alternative, as other sources of capital have become unavailable or uneconomic. We see this trend continuing to benefit Essential Properties as 97% of our 2022 investments were sale leaseback transactions and we remain well positioned to reliably deliver capital to our relationships. From an industry perspective, carwashes are our largest industry at 13.2% of ABR, followed by early childhood education at 12.8%, quick service restaurants at 11.6% and medical and dental at 11.1%. Of note, unit level coverage for our early childhood education portfolio continues to increase above pre-pandemic levels as our operators are seeing strong pricing power and a better labor environment, which has allowed our facilities to further increase their enrollment. From a tenant concentration perspective, our largest tenant represents 3.4% of ABR at quarter end, and our top 10 tenants now account for only 18% of ABR. Tenant diversity is an important risk mitigation tool and differentiator for us and it is a direct benefit of our focus on unrated tenants and middle market operators which offers an expansive opportunity set. In terms of dispositions, we sold 26 properties this quarter for $75.5 million in net proceeds at a 6.9% weighted average cash yield and a weighted average unit level coverage ratio of 2.1x. As we have mentioned in the past, owning fungible and liquid properties is an important aspect of our investment discipline as it allows us to proactively manage industries, tenants and unit level risks within the portfolio. This record level of disposition activity was in response to the capital markets volatility experienced in the back half of 2022, and our desire to lower our reliance on raising new capital. While we do not anticipate our elevated level of quarterly dispositions to persist, we do expect our disposition activity to remain well above our trailing eight quarter average of $27 million through at least the first half of 2023. With that, I would like to turn it over to Mark Patten, our CFO who will take you through the financials and balance sheet for the second quarter.

Thanks, Pete, and good morning, everyone. We had a fantastic fourth quarter with, as Pete noted, a record level of $328 million in new investments, notably at a 7.5% cash cap rate. Our portfolio continues to produce consistent internal rent growth as evidenced by our same-store rent growth coming in at 1.6% and our balance sheet and liquidity remain highly supportive of our growth for 2023. Among the headlines last night was our AFFO per share, which on a fully diluted per share basis reached $0.39 in the quarter. That's an increase of 5% versus the fourth quarter of 2021. On a nominal basis, our AFFO totaled $55.8 million for the quarter, up $10.4 million over the same period in 2021. That's an increase of nearly 23% and up over 4% compared to the third quarter of 2022. For the full-year ended 12/31/22, our AFFO per share totaled a $1.53 per share on a fully diluted per share basis, which is a 14% increase over 2021. On a nominal basis, our full-year 2022 AFFO increased by 32% over 2021 or $50.8 million totaling $208.8 million. Total G&A was just $6.5 million in Q4 2022 versus $5.8 million for the same-period in 2021 with the majority of the increase relating to an increase in non-cash stock compensation expense. Our Q4 2022 cash G&A was approximately $4.3 million and was sequentially lower to Q3 2022 by approximately $1.3 million, which was impacted by the absence of the 250 grand we expensed in Q3, representing the cost we incurred to amend our 2027 term loan to reduce the rate grid on that borrowing and our reduction of our 2022 bonus accrual in the fourth quarter. Our cash G&A as a percentage of total revenue was 5.8% for the quarter and 7% for the full-year 2022, which compares favorably to the 9% and 10.6%, respectively for the quarter and full-year of 2021. On an annual basis, we continue to expect our cash G&A as a percentage of total revenue to rationalize in 2023. Turning to our balance sheet, I'll highlight the following. With our $328 million in 4Q 2022 investments, our income producing gross assets reached $4.1 billion at year-end. From a capital markets perspective in the fourth quarter, we completed the sale of approximately $22.2 million of stock all on a forward basis on our ATM program. We settled that forward in early January 2023 along with the shares we sold in January 2023, generating total net proceeds of approximately $39.2 million. From a debt perspective, I'll reaffirm that during the quarter, we swapped to fix all of the remaining $150 million that we drew in October under the $400 million 2028 term loan. Our net debt to annualized adjusted EBITDAre was 4.6x at quarter end. Adjusting for the proceeds from the forward sale, we completed in the quarter our net debt to annualized adjusted EBITDAre was 4.5x. We are committed to maintaining a conservative balance sheet and investors should expect us to remain well within our historical leverage range of 4.5x to 5.5x. At quarter end, our total liquidity stood at nearly $700 million. Our conservative leverage position, strong balance sheet, and significant liquidity position continues to be supportive of our current investment pipeline and sufficient to fund our growth plans in 2023. Lastly, I'll mention that our current investment pipeline, the outlook for our core portfolio and our continued strong performance at the end of 2022 provided us with the basis to maintain our 2023 AFFO per share guidance range of $1.58 to $1.64, which as Pete mentioned, implies a more than 5% year-over-year growth at the midpoint. With that, I'll turn the call back over to Pete.

Thanks, Mark. Operator, please open the call for questions.

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Thank you. And our first question is from Haendel St. Juste with Mizuho. Please proceed with your question.

Hi. Good morning. This is Ravi Vaidya on the line for Haendel. Hope you guys are doing well. Understanding that 1Q, the transaction activity that's occurred in 1Q so far is not necessarily the run rate for the whole year. Can you talk about your perception of the transaction market today and how that feels compared to prior years in the first quarter?

Yes. I think, listen, I wouldn't read too much into the quarter-to-date activity. Normally, the cadence in the first quarter is a slow January, given sort of the hangover effect from what you typically is a very active fourth quarter. But the transaction market is pretty interesting in that. There is a slightly diminished level of transaction activity given what's going on in the capital markets. But that's also offset by a severely diminished set of competitive set. And so such that – those balancing factors make us feel really good about the pipeline we're seeing and the opportunities that we're working on.

Great. That's helpful. Just one more here. Given the portfolio mix, a number of private equity backed tenants, can you comment on your watch list right now and how's that changed over the last few quarters? Are you noticing any margin thinning for any of the companies as labor gets more expensive or has demand come in from many retailers from consumers as well?

Yes. I would – our watch list isn't related to private equity ownership in any way. The vast majority of our portfolio is privately held and that could be private equity owned or individual – private individuals. But overall the watch list is, is we define it, which is the intersection of single B minus credit and coverage less than 1.5x is at 50 basis points, which is as low as it's been. And overall, the portfolio is in great health, you see that in our same-store sales number that we reported as well as our occupancy, which, at 99% and 1.6% are pretty healthy. So portfolio is in great shape, coverage moderated a little bit, as I said in the prepared remarks, which we think is a result of kind of the inflationary pressures and the lagging effect of our tenant's ability to push that through, but at 4x it's really nothing that gives us concern.

Got it. Thank you, guys.

Thank you.

Thank you. And our next question is from RJ Milligan with Raymond James. Please proceed with your question.

Hey, good morning. A couple of questions. My first is it looked like, 5-Star became a top tenant this quarter, and I'm just curious because it does seem like a slight deviation from buying fungible boxes. Curious if you could give any more color on that incremental investment. How much was it and sort of the thought process there?

Yes. So 5-Star really had been in our portfolio for a while and they were formerly [TRAX] and they rebranded as they did another add-on investment. We think those assets are pretty fungible and several of them are kind of in the family entertainment space, with high land value and long operating history of great unit level economic and coverage and a great operator with great assets and we're happy to have them in the top 10.

Okay. And then question for Mark. Most of the forwards here have been used up, and I'm just curious in the short-term, how do you anticipate funding growth just say over the next two quarters? Do you anticipate using the line for that or could we anticipate additional potential forwards coming?

I appreciate that question. I think what you could anticipate is that sort of embedded in our guidance is not needing to access incremental debt, but rather use the revolver. In terms of equity, I think, if it was ATM, if it was equity activity mostly, it would probably be opportunistic under the ATM, but we really don't need to do anything of a material nature to hit our midpoint. So in the next two quarters certainly nothing of significance.

Great. That's it for me. Thanks guys.

Thanks, RJ. We appreciate it.

Thank you. And our next question is from Josh Dennerlein with Bank of America. Please proceed with your question.

Yes. Hey, guys. I am just curious if you're under your own underwriting or if you're seeing kind of competitors for assets kind of changing their IRR hurdles at all, just given the changes in the cost of capital?

Yes. Listen, I can't really speak to what other people are doing. Obviously, I think the leverage buyer who's seen debt costs rise materially and have severely are challenged in the current market environment with the current availability and cost of underlying financing. As we look at opportunities, you can see our cap rates have moved 40 basis points sequentially in the quarter. And we feel good about the opportunities we're seeing and our ability to kind of move rates. I'd also point out in the quarter are – lease tenor was higher at 18.7 years versus 16.5 years in the third quarter, and our escalations were higher. So overall, we're getting a more favorable economic package in the deals we're doing. The deals in the quarter were 95% repeat business. So guys that we have dealt with in the past, and so that would clearly indicate higher embedded IRS inherent in those deals which kind of goes along with the cost of capital.

Yes. I appreciate that. That's good color. And then within like the industry verticals that you like to acquire, are there kind of better opportunities out there, like as far as like where you're seeing the most deal volume coming through?

Yes. We tend to invest and we tend to tell people that we will invest radically, largely because that's where our relationships reside and that's where our sourcing activity is conducted and across those 16 verticals and it may ebb and flow, any given quarter, the fourth quarter was very heavy in carwash activity for us. Quite frankly for the first couple quarters of the years that sector was pretty hot from a cap perspective and many deals were pricing away from us and we are choosing to transact in other sectors. But for whatever reason, those operators didn't have as many capital opportunities in the fourth quarter and we were able to strike some nice balance there. But overall, over a longer period of time, Josh, I would expect the portfolio to grow ratably.

Thank you.

Thank you. And our next question is from Greg McGinniss with Deutsche Bank. Please proceed with your question.

Hey. Good morning, with Scotiabank. I'm trying to reconcile between comments made last quarter regarding potentially moderating acquisitions and maintaining guidance this quarter despite record Q4 on transactions, significant liquidity and healthy sale leaseback environment. Is guidance being maintained due to the level of anticipated dispositions in the first half of the year? Or any color you can provide on the puts and takes would be appreciated. Also, around what cap rates do you anticipate on those asset sales?

Yes. Listen, I think in the asset sales, just tackle that one. I would expect something in the mid to high-6s and if you're a conservative underwrite 7, but clearly we think there's good liquidity for our properties on an individual basis and we'll continue to sell into that market. As it relates to guidance, it's early in the year and there remains a lot of turmoil in the capital markets. And we feel – I would say we feel incrementally much better today than we did when we first issued guidance based upon some of the factors you mentioned, our execution in the fourth quarter, the dynamics in the sale leaseback market, and quite frankly, the first quarter pipeline that we see, but it's still early in the year and we'll certainly continue to evaluate guidance and as the year progresses, but at this point we're just affirming our guidance.

Okay. Thank you. And on dispositions, are there any, I mean, what types of assets are you looking to offload? Are those in a particular industry, particular tenants? Are you just kind of finding the ones where you can get this good cap rate to help fund future growth?

Yes. It's certainly not that, we're not cherry picking and trying to sell the assets that garner the most attractive cap rates. If that were the case, I would expect our best assets to sell in the 5s. We're really looking at assets with coverage levels or trends at the unit level that would indicate it's not going to be the healthiest asset over a long period of time. And oftentimes, we're selling assets out of a master lease, so that we can improve our whole position. So by and large, it's de-risking sales getting rid assets that just we don't think are going to be as durable for the 20-year period as we would like.

Okay. Thank you.

Thank you.

[Operator Instructions] Our next question is from Nick Joseph with Citi. Please proceed with your question.

Hey, good morning. It's Nick Kerr on for Nick Joseph. So a bit of a follow-up, but you all decided the $228 million investment activity per quarter previous presentations and obviously Q4 is above that. So just curious how we should sort of run rate that as a baseline going forward that it's going to be north of that $228 million or similar?

Yes. Well, listen, as we always do, kind of guide people towards the eight quarter average is a good indicator of what to expect as, but we really have visibility on our pipeline out past 90 days such that we're uncomfortable giving more precise investment guidance around that. Historically, and one of the reasons we provide historical quarter-over-quarter guidance or quarter-over-quarter activity, the fourth quarter is heavy and I think this fourth quarter is consistent with that. And I think the first – as we look at the first quarter, we feel pretty good about what we see. But I think as we said in the context of providing guidance, we would expect a more moderated level in the back half of this year. And that may change as the year plays out. But as we said today, we feel good about the first half and we'll see what comes in the second half.

That's really helpful. Thank you. And then on guidance, so how do you see the economic environment affecting the tenant base and how much credit loss, if any, is taken to those numbers right now?

Yes. Actually, so what I'd tell you just from a modeling standpoint, if you look at the range, you could just assume that there's a healthy level of credit loss at the bottom end of the range. So we've incorporated that and effectively as you move up that range, you're really moving up towards our more historical loss experience, which is probably 30 basis points. But candidly, as you discovered in 2022, certainly as you saw in our same-store growth, we had limited credit loss. And so oftentimes that can be a pretty good tailwind for us as we move through the year to kind of get ability to adjust our guidance.

Awesome. Thank you. And looking forward to see you guys at the conference.

Yes.

Thanks for hosting. We're looking forward to it.

Thank you. And our next question is from John Massocca with Ladenburg Thalmann. Please proceed with your question.

Good morning.

Good morning, John.

Hey, John.

So maybe going back to dispositions a little bit. As we think about loan repayments from the loan book, is that something that could moderate over the course of 2023 versus what was done in 2022 given the cap rate environment that's out there for those tenants and – or was kind of 4Q – 3Q to 4Q shift, just kind of the inherent lumpiness in repayments?

Yes. I think it's good. That's just the inherent lumpiness of repayments. I would – the loan book is pretty small and it's not material, part of our asset base. And those repayments tend to be episodic. I would suggest, we have some loan that are repaid through the sale of individual assets and that kind of tends to dribble in. And so I would expect that dribble in sort of repayment to persist throughout the year because that market remains open and attractive with 10/31 buyers continuing to transact and sell and which results in those loans being repaid to us. On occasion those loans are refinanced out and that becomes a little more chunky. I would expect that to be a little more challenged in the current market environment where the big chunks of repayment coming back to us are a little less probable. But again, it's not a big part of our book and I wouldn't expect it to have a material impact on our numbers.

As we think about the impact on NOI, are those typically repaid right at the same rate that they were issued at? Or is there some kind of, I guess, economic benefit that accrues to EPRT on the sale in terms of bonus or additional penalty stuff?

Yes. I mean, on occasion, we have prepayment penalties and you see that that flow through our numbers on when it happens, that's not on all of the loans and it tends not to be material. We've always said that our loan book tends to carry the same rate as our investments. So that money probably went out the door, like our investment capital, call it in the low-7s. And if we're getting it back today, we're able to redeploy that kind of in the mid to high-7s, so there could be some economic impact there.

Okay. And then apologies if I missed this earlier on the call, but have you seen, as you look at the pipeline, you gave the cap rate on acquisitions closed to-date, but looking out on the pipeline, maybe what's under LOI as well. Are you seeing kind of additional cap rate expansion versus what was seen in 4Q or is are things stabilizing a little bit given maybe the interest rate environment?

It feels like they're stabilizing. And so our first quarter pipeline is not materially different than the fourth quarter. And so it doesn't – our cap rates aren't going to eight, but certainly not back to seven. And so I think that the mid-7s is a good indicator.

And then one last question on acquisitions. The competitive set, you mentioned it was kind of smaller than it had historically been. I guess maybe just in terms of what you're seeing at the table as you kind of look at deals and negotiate with potential tenants. I mean, are people potentially drifting more into your space that has historically played in the investment grade or the more kind of publicly traded names on a sale leaseback basis? Or is that I guess not happening?

Yes. I mean, I would first off encourage you to think about the competitive set not only as sale leaseback buyers, but alternative sources of capital. And that's the much bigger impact is that, bank financing, leveraged lenders and asset-backed lenders. They're all challenged and our tenants just have fewer capital alternatives to capitalize their growth, which is making more and more of them turn to say a leaseback capital as an alternative. And it's really a very unique window and time where there's such dislocation in the overall capital markets that allow us to kind of lock in these attractive returns 20-plus years. As it relates to sale leaseback, competitors clearly, as I said in the prepared remarks, some of the leverage buyers are less aggressive and we are seeing some incremental competition from some of the public peers. But really that's at the margin and the bigger factor is that financing is challenging all over the place and more and more people are forced to look, to say leaseback capital as a means of financing their growth.

Okay. That's very helpful. And that's it for me. Thank you very much.

Thank you, John.

Thank you. And our next question is from Tayo Okusanya with Credit Suisse. Please proceed with your question.

Yes. Good morning, everyone. I just wanted to go back to the commentary you guys made about still uncertainty in the credit market. And specifically, I'm trying to understand what's happening with your middle market tenant base as it pertains to access to capital whether that's causing any kind of financial distress which could have impact on rents or whether, again, the financial distress could potentially even create opportunities for you guys to do sale leaseback transactions with some of these tenants on a going forward basis?

Yes. Most of our tenants – the vast majority of our tenants have long capital that's locked in, in form of debt equity and real estate capital. And really the financial stress really comes from operating stress or operating under performance, which we are not seeing. And so as we said, our portfolios in great shape, our tenant watch list is as low as it's been in a long time, our coverages are very high and our tenants are doing very well and we feel good about that. To the extent that there were any issues as Mark indicated, that would be baked into our guidance. But overall, we feel really good about the underlying credits in the portfolio and their operating performance, which in owning their operating real estate is our primary concern. And you can see our coverages are very strong. Our occupancy is 99.9%, and our flow through of rent escalations in 2022 was virtually a 100%, all good indicators of solid credit performance. The lack of capital availability and the capital markets more pertains to their incremental growth and financing their M&A ability, which at the margin is creating incrementally more opportunities for us to deploy capital at attractive rates.

Okay.

Thank you. As there are no further questions at this time, I would like to turn the floor back over to Mr. Pete Mavoides for closing comments.

Great. Well, thank you all for your time today. We look forward to seeing everyone at the upcoming conferences and please feel free to reach out if you have any questions. Have a great day.

Ladies and gentlemen, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.