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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen, and welcome to Essential Properties Realty Trust Second Quarter 2018 Earnings Conference Call. [Operator Instructions] This conference call is being recorded and a replay of the call will be available 2 hours after the completion of the call for the next 2 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 at Essential Properties. Thank you. You may begin.
Thank you, operator, and good morning, everyone. We appreciate you joining us today for Essential Properties' first conference call as a public company. Here with me today to discuss our second quarter results are Pete Mavoides, our President and CEO; Gregg Seibert, our COO; and Hillary Hai, our CFO. Before I turn the call over to Pete, I'd like to say that during this conference call, we'll make certain statements that may be are considered to be forward-looking statements under federal securities law. The company's actual future results may differ significantly from the matters discussed in these forward-looking statements, and we may not release revisions to 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 on the company's filings with the SEC and in yesterday's earnings press release.
I would now like to turn the call over to Pete Mavoides, Essential Properties' President and Chief Executive Officer. Pete, please go ahead.
Thank you, Dan, and thank you to everyone, who has joined us today for your interest in Essential Properties.
We are very excited to be hosting our first earnings call since completing our transformative capital raise in late June, which included an initial public offering and a concurrent institutional private placement.
I would like to start by thanking the investors that supported us throughout the IPO process as well as thanking Eldridge Industries, our institutional capital partner. We believe this capital raise was a strong vote of confidence, and the quality and transparency of our portfolio, the differentiated and focused way that we deployed capital into net lease investment opportunities and our potential to deliver outsized futures growth for investors. As of June 30, our portfolio contains 604 single-tenant properties that were 99% leased to 134 tenants, operating in 15 targeted industries with 90% of our cash ABR, or annualized base rent, coming from tenants that operate in service-oriented and experience-based businesses. These favorable metrics are a direct output of our strict adherence to a disciplined investment strategy over the past 24 months and it reflects the many lessons learned over the team's collective 45 years of experience, managing and investing in net lease assets.
In our view, we have one of the most transparent and e-commerce-resistant portfolios in the net lease industry as we have avoided many of the legacy problems and at-risk sectors that a more seasoned portfolio may encounter. Today, we will walk through our second quarter, which generated record results, compelling growth of assets and serve to continue to diversify our portfolio and extend our weighted average lease term to 14.3 years. During the quarter, we invested $214 million in 86 high-quality net leased properties at a weighted average cash cap rate of 7.6%. The weighted average lease term of these assets was 17.2 years, and the weighted average annual rent escalation was 1.7%. As a percentage of cash ABR, approximately 90% of our second quarter investment activities came via sale-leaseback transactions; 85% were subject to master lease provisions; and 96.5% are required to provide us with corporate and unit-level financial reporting on a regular basis. These statistics speak to the quality and consistency of our investments and the long-standing industry relationships and disciplined focus of our team. I would note that our second quarter investment activity exceeded our forecast of $207 million as outlined in our S-11 filing. From a portfolio health perspective, our portfolio has a strong weighted average rent coverage ratio of 2.8x, and over 75% of our cash ABR has rent coverage ratio of over 2x or better. Based upon our historical data, a tenant with 2x rent coverage or better has a very high probability of not only renewing their leases at maturity, but staying committed to the properties that we own.
With that in mind, we believe we have constructed a highly transparent and fungible portfolio of net lease assets, which gives us unprecedented visibility and liquidity to see and manage potential risks in this portfolio. This deliberate portfolio construction has resulted in what we believe to be an incredibly compelling supplemental disclosure after only 2 months as a public company. This ongoing disclosure, combined with the fact that all of our investments were made within the past 2 years to give investors great comfort and security and predictability of our future earnings. In terms of growth, we are highly optimistic entering the second half of the year, having delevered our balance sheet to 3.9x net debt to annualized adjusted EBITDA (sic) [ EBITDAre ], which includes the impact of the greenshoe that occurred in late July. Combining our current cash balance of over $150 million, with our undrawn and fully available $300 million unsecured credit facility, we have over $450 million of liquidity to capitalize on our growing investment pipeline.
As we look out to the second half of 2018, we continue to source investment opportunities that will allow us to accretively deploy capital into high-quality investments that can further improve the diversity of our portfolio and continue to grow earnings. In fact, as we disclosed in our 10-Q yesterday, subsequent to the quarter's end, we had invested another $41 million into net lease properties as of August 7.
Our objective is to maximize shareholder value by generating attractive risk-adjusted returns through owning, managing and growing a diverse portfolio of assets, leased tenants operating in service-oriented and experience-based industries. These returns will come from a combination of growing our cash available for distribution and paying our current dividend.
To that end, as disclosed in our S-11 filing, we anticipate paying an $0.84 per share initial annual dividend. I would anticipate our board to review that dividend policy and make a declaration for the third quarter and the 5-day stock period very shortly. We are thrilled to be operating in the public markets again, and we see our record second quarter investment activity as a tangible indication of our ability to reliably, selectively and consistently grow our portfolio with properties that match our articulated investment criteria. We look forward to engaging with investors and analysts in the coming weeks and months as we plan on attending various conferences and other events in the back half of the year.
In closing, our quarterly results are a culmination of nearly 2.5 years of effort, invested in building out an experienced team of net lease professionals and developing the systems required to source, underwrite, close and manage a diverse portfolio of single-tenant net lease assets. I would like to recognize and thank the team for their efforts. They've invested in constructing this portfolio and positioning our company for continued growth. With that, I'd like to turn it over to Hillary Hai, our CFO, who will take you through the financials for the quarter. Hillary?
Thank you, Pete, and good morning, everyone. As Pete mentioned, we completed our initial public offering in concurrent institutional and private placement during the quarter. Net proceeds were used to pay down $334 million of notes payable. Concurrent with the IPO, we also entered into a $300 million unsecured credit facility, which remains undrawn and fully available.
We ended the quarter with $590 million of debt related to our master trust funding program and $140 million in cash and restricted cash. Our net debt to annualized adjusted EBITDAre decreased to 4.4x for the quarter, and when factoring in the net proceeds from the partial exercise of the greenshoe, this leverage ratio declined to 3.9x.
Going forward, our capital capacity remains strong with $450 million of liquidity consisting of approximately $150 million in cash and $300 million of availability on our credit facility as of August 7.
Now turning to our income statement. Our second quarter results were combined for pre- and post-IPO, except for earnings per share which is for the sale period only. Total revenue for the second quarter increased 63% to $21.7 million as compared to $13.3 million for the same quarter in 2017. The increase was primarily due to our robust investment activity. Adjusted funds from operations or AFFO for the second quarter increased 68% to $8.5 million as compared to $5 million for the same quarter in 2017.
On the G&A front, we continue to increase our operating efficiencies. SG&A for the second quarter declined to 14% of total revenue as compared to 18% a year ago. Asset portfolio continues to grow and scale. We expect to see our G&A as a percentage of revenue to decline as we largely have the infrastructure in place to execute our business plan. Also in the quarter, we reported $907,000 of noncash expenses related to impairment of 8 properties. As a part of the asset management process, we regularly review our portfolio and strategically seek to dispose properties that do not fit our long-term investment criteria. 7 of the impaired properties were acquired in the GE seed portfolio transaction, which included 4 vacant sites, 2 leased assets and 1 leasehold interest.
With that, I'll turn the call over to Gregg Seibert, our COO.
Thanks, Hillary. During the quarter, we invested $214 million in 86 properties at a weighted average cap rate of 7.6%.
The weighted average rent escalation for these properties was 1.7 and the weighted average lease term was 17.2 years, which helped to increase our portfolio's weighted average lease term to a compelling 14.3 years.
As has been the case over the last 7 quarters with our investment activity, which we detailed on Page 7 of our supplemental, the vast majority of our second quarter investments were originated through sale-leaseback transactions that are subject to our lease form with master lease provisions and ongoing financial reporting. This is our hallmark of our platform at Essential Properties. We utilize our long-standing relationships in the net lease space to consistently source investment opportunities that fit with our investment parameters and offer attractive risk-adjusted returns. From an industry perspective, restaurants are our largest factor at quarter end at 27% of cash ABR with quick service restaurants, or QSRs, being our largest industry at 14%. We believe the QSR industry provides a combination of highly stable industry performance and attractive real estate fundamentals, which makes it one of our best performing sectors in our experience. While we would expect our overall restaurant concentrations to drift lower as we expand the portfolio, we expect to maintain QSRs as one of our leading industry segments, given the current makeup of our investment pipeline and our long-standing relationships in that space. Looking at our portfolio more broadly, 90% of our cash ABR at quarter end was derived from tenants that operate service-oriented and experience-based businesses, which has been a deliberate focus for Essential since we have started acquiring properties over 24 months ago.
We believe tenants that are focused in these industries and more importantly, real estate occupied by these tenants, are more heavily insulated against e-commerce pressures, which gives us confidence in the durability and predictability of our new rents. As Pete alluded to earlier, by having a New York portfolio vintage, we have avoided many of the challenge in at-risk retail categories.
From a tenant concentration perspective, QSR chain Captain D's is our only tenant with over 5% of cash ABR, and we anticipate this concentration will move under 5% within the next 2 to 3 quarters. With that in mind, our top 10 tenant concentration sequentially declined 320 basis points to 38.6% of cash ABR at second quarter end, which you should expect to see as a reoccurring theme as we add new tenants to the portfolio each quarter. In fact, in the second quarter alone, we added 3 new tenants to the top 10, including preschool operator, Malvern Schools; convenience store operator, R-Stores; and gym operator, Latitude Fitness. All of these sales-leaseback transactions were originated with high-quality middle market tenants occupied real estate and service-based industries.
Moving on to asset management. Our portfolio remains healthy with a weighted average rent coverage of 2.8x and over 75% of our cash ABR having a rent coverage ratio of 2x or better. In addition, with 97.4% of our tenants by cash ABR required to report their unit-level financials to us, we have near-realtime transparency into the health of our tenants and the profitability of our locations. This is an important risk mitigation tool as we routinely identify and sell assets that no longer fit our long-term investment objectives in order to redeploy that capital. With our average asset size being $2 million, our portfolio is mostly comprised of highly-fungible granular properties that are easier to sell and re-lease. To that point, we sold 10 properties during the quarter for $14.5 million in gross proceeds, which resulted in a $2.4 million gain on sale. Excluding 1 property sold pursuant to a pre-existing tenant purchase option, the cash cap rate on the 7 leased properties that we sold was 7.1%.
With that, I turn it over to Pete for his concluding remarks.
Thanks, Gregg. To reiterate, we are very excited to, again, be partnered with public market investors to execute our business plan. We believe we have a clearly delineated and actionable investment strategy that can now allow us to deploy the recently raised capital and continue to grow our portfolio, diversify our risks and rationalize our G&A.
With that, operator, we'll take the first question.
[Operator Instructions] Our first question comes from Nick Joseph with Citi.
It's a busy acquisition quarter. I appreciate the update, I guess, through August 7. What does the pipeline look like for the back half of the year?
Nick, thanks. Kind of as we said, we're optimistic about the backlog that we have. Going into the transaction, we're very clear that we have staffed this organization kind of be able to transact, and we had a $110 million a quarter sort of run rate for the past 7 quarters and obviously, the second quarter of this year was a big quarter for us. Transaction volume will ebb and flow, but as we think about it, that $100 million feels like the right number.
And then unit-level rent coverage still solid, but margin ticked down at 2.8x. Is that the result of the 2Q acquisitions or something in the existing portfolio?
Mostly, it's related to the 2Q acquisitions and if you look at the disclosure on Page 7, the coverage on those deals was 2.4. And so if you assume 20% of the portfolio coming in at 2.4, and blending to the existing portfolio, you can kind of see the trends there. I would say that the individual coverage for any given quarter will vary depending upon the mix of industries that we do in that individual quarter. Some of our industries have lower coverage and others have higher and it really -- it will ebb and flow depending upon that mix.
Our next question comes from Sheila McGrath with Evercore ISI.
Looking at the same-store NOI calculation for the quarter, it was 1.7%. Is that within the typical range that you expect? And are the lease escalations highlighted on that page for retail and service, are those generally higher than experienced tenants?
Yes, Sheila, I would say, kind of 1.7% is right down center plate and center mass of our escalations. Some of our escalations have CPI indexers, which may drive it up or down. And so I think on average, 1.7% is kind of where the portfolio sits, and depending on credit loss in a given quarter, it may go down or go down a bit and CPI may drive it up. To the industry mix, generally, it's equal across all of our tenants, and it may just be kind of timing of those bumps as it relates to those specific sectors.
Okay. Great. And as a follow-up, just -- you do consistently have quarterly asset sales in your history. I was just wondering if you could discuss the thought process on which assets you target for sale. Are they lower coverage or just how that process works?
Yes, we generally -- in general, we're trying to sell out of assets that don't meet our long-term investment criteria and really that means, we see a lower probability of renewal on that. It's primarily driven by coverage or tenant credit or kind of real estate fundamentals as it relates to that specific property. So we do receive unit-level and corporate financials from a high percentage of our tenants on a quarterly basis. Our asset managers are reviewing those financials and really looking for trends that would indicate declining health that would give us a heads-up to get out of some of our assets. I would also add, we started this platform with a large portfolio deal in the GE Seed portfolio, and any time you buy a large portfolio, you're going to have some level of asset management and disposition to kind of manage that. And so that sort of contributed to a lot of the early sales, but you should expect us to continue to be transacting on the disposition side. As Gregg pointed out in his comments, we've constructed this portfolio to have good liquidity in the real estate assets that we own with an average asset size of $2 million. And so that's an important part of how we run our business and really getting out in front of risks and selling assets and recycling that capital is an important part of what we do.
Our next question comes from Ki Bin Kim with SunTrust Robinson Humphrey.
Can you talk about your philosophy and strategy in terms of acquisitions. And during this quarter, how much were kind of brokered, open-market deals versus direct dealings?
Yes, we -- I think our acquisition strategy is clearly focused on fungible real estate, originated through sale-leaseback transactions with middle-market tenants and finding deals that we feel meet long-term investment criteria and provide master leases and unit-level coverage and all of the things that make it compelling for us to own for a long period of time. As we disclosed in our S-11, a high percentage of our deals have been with counterparties that we've transacted with in the past. I think the stat in the S-11 was 53% was with operators, and I think over 80% was with other counterparties. As for the specific mix of deals in the quarter, I don't have that necessarily broken out. We did disclose the percentage of sale-leaseback transactions, transactions where we're sitting down, negotiating a lease on our form and providing capital into a capital-needs situation and 90% of the transactions during the quarter were sale-leaseback transactions, which we feel to be pretty compelling.
Okay. And you said you sold 10 buildings this quarter, 4 of which were vacant. When you combine all that together, what was the recovery rate on gross cost?
Recovery rate on gross cost, I'm going to ask Hillary.
We didn't sell 4 vacant sites this quarter. This is related to impaired site for this quarter. We haven't sold those, but we sold 2 vacant sites this quarter.
So if you look on Page 8 of our supplemental, Ki Bin, I think we sold 10 properties, 8 of which were leased, 2 were vacant for $13.7 million, and I think the gain on that -- what was the gain number there, Hillary?
It was roughly $3.5 million, $3.6 million.
So the $3.5 million gain, keep in mind, I mean, it's the longest we've owned an asset is 2 years, most of them were shorter than that. But so there has not been much depreciation.
Okay. And when you guys quote unit-level coverage, I guess, a couple of questions. One, what is the median unit-level coverage for your portfolio? And second, is it 4-wall coverage or is it in some other definitions, what do you call kind of a corporate coverage, including some allocation of G&A. In fact, the corporate level at -- to the properties so that coverage will be a little bit lower -- I just want to make sure that I understand the definition correctly?
Yes. Do we have the median handy?
Yes. The median is 2.5, Ki Bin.
So the median is 2.5, and that's a pure 4-wall cash coverage. We do look at allocated G&A internally. We disclosed a more pure number because that G&A can vary widely depending upon the industries and we just provide more of the consistent number on a cash basis across portfolio.
Okay. And just last question, on the corporate structure, and personal and G&A. You have -- I think you have about 20 people in the company. As you see yourself growing the portfolio over the next couple of years, how should we think about the G&A low for the company and how many people you plan to hire along the way?
Yes, I think as we look at it, we're pretty well staffed. We're certainly, from a cost perspective, we're staffed at the senior executive level, which tends to be the most expensive employees. And so there will be some additional associates and analysts and lower-level professionals. Over time, I wouldn't see us growing. I think at the time we took Spirit public in 2012, that was about $3 billion and 40 employees. And I guess, if we were to double this portfolio, and we probably wouldn't double it to 40 professionals, but we will grow incrementally. But overall from the G&A perspective, that should come down as we continue to grow the portfolio.
[Operator Instructions] Our next question comes from John Massocca with Ladenburg Thalmann.
So can you walk us through the underwriting process for Malvern Schools that you just added to the top 10 list? What kind of gets you comfortable with an early education operator and how fungible do you see those assets being?
Early childhood education is one of our top segments. It's one of our targeted industries and we feel very comfortable, both with that industry and with the real estate occupied in that industry. I don't want to specifically get too detailed on individual tenants, but I would tell you that Malvern Schools is a great operator, has a dominant market presence in the markets that they operate and has done a great job in building that brand and kind of covering that suburban Philly market and has what we believe to be pretty compelling growth prospects, growing that brand. In any transaction, generically, we're underwriting the corporate credit and the balance sheet and cash flows to support that balance sheet of the corporate credit. We're underwriting the units, the performance of the business operating inside of those units and then lastly, we're underwriting the real estate and the quality of that real estate and our basis in the real estate as it relates to the markets that they're in. Specifically as it relates to the fungibility of early childhood education properties, I would say, first and foremost, The Malvern Schools were performing very well at a high level, as early childhood education sites, and I think would be attractive to any number of early childhood education providers to the extent that Malvern were to have an issue, which would be a shock to us because it's an excellent company, well-capitalized and performing well. But when you start looking at secondary uses, we certainly felt the in-fill nature of those sites, the high demographic markets that they occupied was overall compelling, and specifically compelling as it related to our basis in those assets.
Understood. And then kind of in the same vein, how do you look at your investments in the health and fitness sector with regards, maybe, full-service gyms versus more of a discount gyms, and is there a different underwriting process there and how you look at the different type of health and fitness assets out there in the market?
Yes, we certainly -- we own some of both. I would say we're predominantly doing sale leasebacks with operators where we get historical unit-level performance. So in general, the gyms we're buying, whether they'd be full-service or discount providers, are well occupied and a have a proven ability to support the rents that they're paying us. Clearly, the discount guys operate a different type of real estate and that real estate just has a different underwriting methodology. It tends to be more fungible and lower rents, but really we're doing a traditional real estate underwriting of every asset that we purchase and making sure that, to the extent that our tenant were to have issues, we'd be able to replace those rents.
Ladies and gentlemen, we've reached the end of the question-and-answer session. At this time, I'd like to turn the call back to Pete Mavoides for closing comments.
Great, and thank you all for participating in our call today. I hope you gained from this call that we're very excited with our portfolio, we're excited with our ability to continue to grow this portfolio and put this capital to work. We're excited to be in the public markets again, and we look forward to continuing to engage with you all in the coming weeks and months as we continue to execute our strategy. Thanks, again, and have a great day.