NNN REIT, Inc. (NNN) Q3 2016 Earnings Report, Transcript and Summary

Welcome to the National Retail Properties Third Quarter 2016 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to your host, Mr. Craig Macnab who is the CEO and Chairman. Thank you. Mr. Macnab, you may begin.

Thank you very much and good morning and welcome to our third quarter, 2016 earnings release call. On this call with me are Jay Whitehurst, our President; and Kevin Habicht our Chief Financial Officer, who will review details of our third quarter financial results, following my opening comments. In addition, Kevin will update you on our guidance plus provide some of the key assumptions for how we envision 2017 unfolding. We have just completed another consistent predictable quarter at National Retail Properties. As indicated in our press release, we're projecting that 2016 will be another year of solid FFO per-share growth and as Kevin will further describe, I am optimistic that 2017 will be another year of growth in per-share results. In the third quarter we had a productive quarter acquiring 38 properties and investing $128 million at an initial cash yield of approximately 7.1%. The average lease maturity for our third quarter acquisitions was 15 years. We're very pleased that so far this year we have invested $596 million in 249 different properties at an initial cash yield of slightly less than 7%. At an average of $2.4 million per retail property, we continue to focus primarily on well-located small box retail real estate. Our fully diversified portfolio remains approximately 99% occupied which is in the range of where we have been running this year. This exceptional occupancy reflects two things. Firstly, the merits of will located retail properties which generate extremely predictable cash flow for a long period of time. And secondly, the success of our selective disciplined acquisition approach, along with our careful underwriting of each and every property that we acquire. Our tenants continue to perform well, despite a lower growth retail environment. From a credit perspective, we congratulate our fourth largest tenant, Camping World, on their successful initial public offering where they raised over $230 million. We have done a great deal of relationship business with Camping World in the last several years and it has been impressive to watch their terrific execution. With regard to the pending lease renewal notification for our 121 property SunTrust Bank branch portfolio, I am pleased to report that we have reached a very satisfactory outcome. SunTrust has renewed 80 of the leases for a 12-year term and they will be purchasing from us another ten properties at a cap rate of approximately 5.6% in early 2017. Value created by these renewals and sales exceeds our purchase price for the entire portfolio. SunTrust will continue to lease an additional 31 properties until April of 2018 and our leasing team is already working to maximize the value of those assets. National Retail Properties continues to be very well-positioned with a strategy of focusing exclusively on the net leased retail sector. Our balance sheet is strong, our portfolio is in excellent shape and from a growth perspective, we have a multi-year track record of sourcing through our differentiated approach. Jay Whitehurst will be inheriting a solid foundation next spring when he becomes CEO and I have every confidence that Jay and Kevin, supported by our excellent team, will take National Retail Properties to the next level. With that, I will hand over to Kevin.

Great, thank you. And I'll start with my normal cautionary statement that we're going to make certain statements that may be considered to be forward-looking statements under Federal Securities laws. The Company's actual future results may differ significantly from the matters discussed in these forward-looking statements and we may not release revisions to these forward-looking statements to reflect changes after the statements were made. Factors and risks that could cause actual results to differ materially from expectations are disclosed from time to time in greater detail in the Company's filings with the SEC and in this mornings press release. With that, headlines from this morning's press release announcing third quarter results include core FFO operating results of $0.59 per share and completing $128 million of new investments while maintaining a low leverage profile and strong balance sheet liquidity. Looking at the nine-month period, we reported core FFO of $1.75 per share and that represents a 4.8% increase over prior-year results and we completed $596.5 million of acquisitions year-to-date. During the third quarter we increased our quarterly dividend by $0.02 per share or 4.6% and that makes 2016 the 27th consecutive year of dividend increases. Our AFFO dividend payout ratio year to date is just under 75%. Occupancy continues to hold up well ending the quarter at 99% and as of September 30, 2016, the annual base rent for all leases in place at quarter end was $527.7 million. We tightened up our 2016 guidance range by $0.01 on the top and bottom end of the range to $2.32 to $2.35 per share for core FFO. We also tweaked the underlying guidance assumptions slightly as detailed on page 7 in the press release. Most notably, after quarter end we completed a $345 million perpetual preferred stock offering which closed on October 11. This preferred issuance was priced with a 5.2% annual yield which is the second lowest preferred coupon in the industry. While immediate use of proceeds went to pay off our bank line and fund near term acquisitions, it does weigh a bit on our near term per-share results. However, we strongly believe that perpetual capital priced at 5.2% is a very attractive price and belongs in our capital stack. This morning we also introduced 2017 FFO guidance of $2.42 to $2.48 per share and AFFO guidance of $2.46 to $2.52 per share which indicates 5% growth in per-share results based on our current assumptions which include $500 million to $600 million of acquisitions in the mid to high 6% cap range with around 60% of those closing in the second half of 2017, G&A expense of $34 million to $35 million excluding any severance charges estimated to be a $8.1 million in 2017, real estate acquisition transaction costs of $1.1 million, no change in occupancy is anticipated, property expenses net of tenant reimbursements of $6 million to $6.5 million and lastly, property dispositions of $100 million plus or minus $20 million. We do not give guidance on our capital markets plans, but you should expect our behavior to remain consistent with the past 20 years, meaning maintaining a conservative leverage profile and getting capital when it's available and priced well, all with a multi-year view, not a one-year view, of managing the Company and our balance sheet. A side note in this regard, a good example, 12 months ago and even just a few months ago, we had no plans to issue preferred stock -- the preferred stock that we issued in early October. We want to maintain a very flexible balance sheet to take advantage of what the capital markets might offer us. So while we clearly do have plans for capital markets activity, we don't publicize them for a variety of reasons and one of those reasons is because market pricing may very well move us off those plans to some degree, as seen with our recent preferred stock offering. For modeling purposes, you should think of us behaving in a leverage neutral manner in 2017. One last item I will mention regarding our third quarter results is the $6 million non-cash impairment charge related to our commercial mortgage residual interest. This item actually was included in our recent preferred stock offering disclosure last month. These residual interests are a small asset and by small I mean 0.2% of total assets small and have been on our books sense 2004. While it's created its share of accounting noise due to the mark-to-market requirements, it has been a home run investment producing $44 million of cash distributions to NNN versus our $9 million investment. This investment was a residual interest in seven commercial mortgage loan securitizations and in September, the loan servicer exercised what is known as their cleanup call option on four of these seven loan securitizations, thereby effectively purchasing all of the trust's assets and terminating future cash distributions to us from those four loan securitizations. We also impaired the value of the remaining three residual interests given what now seems like an increased likelihood of the servicer exercising their cleanup call on those trusts. Turning to the balance sheet, during the third quarter we raised $57 million of common equity, primarily through our ATM and for the first nine months we raised $273 million of common equity. This plus $83 million of year to date property disposition proceeds and $57 million of year to date retained AFFO, if you will, after all dividends, provided $423 million of total equity equivalent proceeds which funded 71% of our $596 million of acquisitions in the first nine months. At quarter end we had $184 million outstanding on our $650 million bank credit facility which as I mentioned, was fully paid off with our preferred stock offering proceeds 11 days after quarter end. So we remain very well positioned from a liquidity perspective. Our weighted average debt maturity is 6.2 years with a weighted average interest rate of 4.5%. Our next debt maturity is $250 million of 6 7/8% notes and they are due in October of 2017. Our balance sheet remains in a great position to fund future acquisitions and to weather potential economic and capital market turmoil. Looking at September 30, leverage metrics debt to gross book assets was 33.4%. As you know, we have never managed our balance sheet around market cap based leverage metric. The more important metric to us is debt to EBITDA was 4.5 times at September 30. Interest coverage was 4.9 times for the third quarter, 4.8 times for the first nine months. Fixed charge coverage was 3.6 times for the third quarter and 3.5 times for the first nine months. Only six of our 2,485 properties are encumbered by mortgages totaling about $16 million. So 2016 is producing another good year of solid growth and per-share operating results. We remain focused on a single property type because we believe retail properties offer better risk adjusted returns over the long term, compared to other single tenant net lease property sectors and our core competency and long track record is in retail properties. We have continued to maintain a conservative balance sheet profile and like the optionality a flexible balance sheet gives us. We manage the Company for the long term, as I said which is evidenced most recently by our recent 5.2% preferred stock issuance. Short term and variable rate capital surely helps per-share results, but comes with risk. Our strategy has been very consistent for years. We're optimistic we will be able to perpetuate our 27 consecutive year track record of raising our dividend which has been an important part of consistently outperforming equity indices and general equity market indices for many years. And with that we will open it up to any questions.

[Operator Instructions]. Our first question comes from Nick Joseph of Citigroup. Please go ahead.

This is John here with Nick. I'm just curious on cap rates. Could you give some color on what you're seeing on individual trades versus portfolio deals?

What we're seeing out there in the world is that cap rates are still tending to compress and push slightly lower. Our cap rate for this quarter, as Craig and Kevin mentioned, was just a little over 7%. For the year we expect our cap rate to be in the high 6%s. And when we look ahead to next year, we think it will be perhaps a little bit lower than that. The range of cap rates for our acquisitions runs from mid 6%s to upper 7%s. And it's consistent across the property types that we're looking at. I should point out that what I'm talking about right now are initial cash cap rates. Our typical leases get about 1.5% annual rent bumps in our lease structure and on a 15 to 20 year lease, that adds 75 to 100 basis points of additional anticipated long term yield, although we don't straight-line any of that.

Have you seen any change in the amount of assets that are on the market given interest-rate volatility and how exactly do you factor in a potential rate hike into that 2017 guidance number for acquisitions?

Well, right now we're not seeing any real change in cap rates out there due to this relatively short term bump that has occurred. We think that we can continue -- hit the numbers that we're guiding to. One reminder there is that we do work very hard to build relationships with retailers. And this year we will do business with close to three dozen relationship retailers. And our value proposition in that instance is more than just lowest cap rate. We're a reliable capital provider that they can count on and that gives us a little better initial cash cap rate and makes the business a little stickier and it gives us a little bit better line of sight to how we're going to perform next year. And then on top of that we're just going to look at every portfolio of retail properties that's out there. We see them now and we selectively underwrite those and pursue the ones that make good risk-adjusted sense to us.

Our next question comes from Vineet Khanna of Capital One Securities. Please go ahead.

And maybe along those lines, can you provide some additional color on the CEO succession? And if there are other moving pieces to the new leadership lineup?

Sure. First, let me just say that I can't thank Craig enough for teeing up this opportunity. Craig has been an outstanding role model and a mentor for me and for our entire management team. And the team is poised and ready to continue on with the mission of creating long term shareholder value. But between now and the end of April, it's really going to be business as usual here at NNN. When we do get around to the transition, right now, we anticipate no other changes in titles. When the transition becomes effective, I will hold the title of CEO and President, but I do really want to point out that we have an experienced executive management team of REIT veterans. Our average tenure of the team is 17 years, led by Kevin who has been our CFO since 1992, so it's a team that has been together for a long time and there is great value in having that institutional knowledge and institutional memory. And we're just going to carry on with the mission that we have been accomplishing for these last dozen years under Mr. Macnab.

And then maybe could you provide an update on the watchlist and specifically, if there have been any changes at Gander Mountain?

Yes, nothing really of note new there. We continue to watch sporting goods retailers a bit. We have talked about Gander Mountain in the past, but everyone is current on rent so there is no immediate immediacy to that, but we always maintain a watchlist of retailers and the usual suspects, Barnes & Noble has been on that list for more than five years, probably closer to ten, but nothing has really changed in that regard.

Okay. And just lastly for me, how has activity in the developer finance program been trending and have you seen any meaningful change in demand or interest there?

No. We have a good pipeline of business in that area. It is a modest part of our overall business. We're primarily focused on dealing directly with retailers, but having a component of our business plan that focuses on financing developers makes good sense to us and provides us with some good opportunities to acquire good new properties and to grow our relationship business with the retailers on those properties. Right now that segment of our business looks typical to what we've done the last few years.

Our next question comes from Vikram Malhotra of Morgan Stanley. Please go ahead.

This is Landon on for Vikram. First of all, we just wanted to certainly pass on our congrats, both Craig and Jay, on the updates there. It has certainly been nice working with you guys over the last several years. I was wondering if you could take us through some more details related to the SunTrust negotiation, maybe the change in cash rent on the 80 renewals and any expected financial impacts included in 2017 guidance?

Landon, absolutely. Just to step back and remind folks again of the overall transaction, we own 121 SunTrust Bank branches with leases that expire in April of 2018. And after a comprehensive negotiation with SunTrust, we settled with them in three components of the overall transaction. First, SunTrust has renewed 80 of the leases for a 12-year term that commenced September 30 of this year. And rents on those 80 leases will continue to increase annually at 1.5% per year during the 12-year term. Second, SunTrust is going to repurchase, from National Retail Properties, ten of their sites at a cap rate of approximately 5.6% which is going to result in sale proceeds of approximately $32 million. These sales are scheduled to close in the first quarter of 2017 and will collect full rent on the properties until the sales close. And I should also note that these ten leases have also been renewed for a 12-year term in the highly unlikely event that SunTrust doesn't close on the purchase transaction. And the remaining 31 properties will continue to pay full rent until April of 2018, after which those leases will expire. So we have 18 months to pursue new tenants for those properties and as Craig mentioned, our leasing team is already on the case. The 80 leases that have been renewed now have a market value, in our estimation, in the range of $185 million to $195 million. And we'll be reaping $32 million in proceeds from the sale of the ten assets back to SunTrust. Our original purchase price was only $210 million for the entire portfolio so we have created significant shareholder value even before you factor in the value of the 31 properties with leases that are expiring in 18 months. And regarding those 31 properties that won't be renewed, as I mentioned, we will continue to receive full rent through April of 2018, so there is no impact on our 2017 revenues. Landon, as you've heard me say before, we're a real estate Company. We have the team and the skills to address these impending lease expirations. The ultimate outcome for those properties won't be known for a few years, but we expect there won't be any material effect one way or the other on our rental income stream that is even right now well over $500 million per year.

This is Kevin, I will just underline one thing, as it relates to impact on 2017, it's really just the sales of the ten properties next year, of $32 million at a 5.65% cap rate which we will able to redeploy that capital accretively. So, 2017 really sees very little impact and whatever there it's a net positive.

Okay. And on the 80 assets, the dollar value of rent, can you give us that? And is that equal to what they were paying prior to the renewal?

Yes, Landon, it is 102% of what they were paying previously. So it bumped annually -- it's been bumping annually during the term of the lease and just will continue to do that straight through the renewals.

Okay. That is very helpful. And then just maybe one more question. Could you take us through anything you are seeing on the restaurant side of the business? Obviously, you had a large transaction with Bob Evans this year. Are you guys thinking of potentially recycling any of those assets since they have been trading at cap rates well inside of what you purchased them for?

Our restaurant portfolio, we're very happy with. I should point out that it is a very diversified portfolio that is split about 60% casual dining and 40% quick service. We have over 750 different restaurant properties leased to over 150 different tenants in 40 states. And our portfolio is performing well, the tenants that we have there are performing well. Our underwriting focus when we acquire these assets is on good real estate locations with strong store level performance and reasonable rents. And all of that helps us mitigate the ups and downs of the tenant's business.

[Operator Instructions]. Our next question comes from R.J. Milligan of Robert W. Baird. Please go ahead.

Quick question on the balance sheet for the model next year. Kevin, you said that we should assume leverage remains neutral. I'm curious in what environment or even in terms of a capital environment, would you consider increasing leverage as you continue to grow next year? And how comfortable -- how far would you increase leverage?

At the moment we don't see a need to do that and still be able to hit our objective in growing per-share results. That's really at the end of the day what we're trying to do to drive shareholder value, is to do that. To the extent we can do that on a leverage neutral basis we will continue to do that. It looks like next year we can. We will look at 2018 and 2019 as it comes, but in the out years, if we're in the mid-4s in terms of debt to EBITDA coverage, that could get to the low 5s at some point, but we don't see that needing to have to happen anytime soon in that regard. We still have some accretive refinance opportunities next year. As I mentioned in October, we've got some 6 7/8% notes that come due that will be able to be accretively refinanced. We've got some preferred that becomes redeemable next year. That's an option as well. So we feel like we still have enough tools to work with to not need to push leverage higher at this point. And I will note, too, as you know, in recent years we have been moving the leverage metrics to the better side in recent years and so we do have some capacity to do that. And lastly, we have full availability on our bank credit facility which we have effectively not used. If you look at our average outstanding credit facility balance over the last several years, it's been under $100 million of usage and so that's another piece of capital that could be utilized to a greater degree than it has in the past.

Okay. And I'm not sure if you can comment, but have you issued any equity on the ATM this quarter and/or would you be comfortable issuing at this stock price?

Third quarter we did. We won't comment to the extent we have done any to date. Typically we don't until earnings anyway. But we will evaluate. As we've talked about, we don't really go into the details of our plans on capital markets activity for a variety of reasons, but we like the fact that we have the optionality to issue or not to issue on the ATM.

[Operator Instructions]. At this time there are no further questions over the audio portion of the conference. I would now like to turn the conference back over to management for closing remarks.

Thanks very much. For those of you that are going to be out in Arizona in two weeks' time, we look forward to seeing you all. Appreciate it. Thank you very much.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful rest of your day.