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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 fourth quarter 2018 earnings conference call. This conference 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 today'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. Welcome, Dan.
Thank you operator and good morning everyone. We appreciate you joining us today for Essential Properties fourth quarter conference call. Here with me today to discuss our fourth quarter results are Pete Mavoides, our President and CEO, Gregg Seibert, our COO and Hillary Hai, our CFO.
During this call, we will make certain statements that may be considered 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 these forward-looking statements to reflect changes after the statements were made. Factors and risks 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 press release.
Before I turn the call over to Pete, I would note that our 2018 10-K fourth quarter supplemental and another investor materials are available on the Investor Relations section of our website.
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 excited to close out 2018, which was an eventful year for Essential Properties. We invested over $500 million growing our net lease portfolio by over 48%, raised approximately $625 million from investors and joined the ranks of the publicly traded net lease REITs.
Looking at the fourth quarter, it was a volatile time for the capital markets. In addition to the VIX being at elevated levels for much of the quarter, the yield on the 10-year U.S. Treasury touched highs not seen since April 2011, before falling nearly 55 basis points to end the year at 2.68% and our short-term cost of capital was impacted as a result. As communicated on our third quarter earnings call, we assumed a more measured pace of new investment activities and a slightly more aggressive posture as it relates to asset dispositions, understanding that if market volatility continued into 2019 we would have ample capacity to operate through any prolonged dislocation. These decisions were reflected in the results we reported yesterday.
In the first two months of 2019, we have seen interest rates and REIT valuations stabilize, which has been a nice tailwind for the market and allows us to continue our growth trajectory. We also see our inclusion in the RMZ, which occurs after the close today, as a true milestone of our company having made our first investment as Essential Properties less than three years ago.
As of December 31, our granular portfolio of 677 single tenant properties was 100% occupied, which speaks to the inherent benefits of owning a recent vintage portfolio of net lease assets. Our properties are leased to 161 different tenants, operating in our 15 targeted industries with over 91% of our cash ABR coming from tenants that operate in service oriented and experience based businesses. We continue to focus on operators within these industries as our tenants' customers must visit our properties to either receive a service or have an experience. We believe this operator customer relationships results in predictable behavior and transparent profitability that supports the underlying rents our tenants pay to occupy our properties.
As of December 31, our properties had a compelling 14.2 year weighted average lease term. Given our portfolio's small, relative size, our historical investment trajectory and our average sale-leaseback transactions having initial lease terms of 15 to 20 years, we expect our portfolio lease duration to remain sector leading for the years to come. This serves to limit future rent erosion from lease expirations and enhances our internal growth, which was evidenced by our same store contractual cash NOI growing 1.9% in the fourth quarter.
In addition, with an average investment of per property of $2 million, our portfolio is highly liquid from a sales perspective and readily fungible from a leasing standpoint, which is an important differentiator for Essential. Based on our experience, there are a large number of prospective tenants interested in and capable of re-leasing smaller properties and there is an exponentially deeper pool of buyers for low price point assets. This inherent granularity serves to facilitate our active asset management philosophy and further diversifies our risk.
Turning to our fourth quarter investment activity. We invested $104 million in 39 high-quality net lease properties at a weighted average initial cap rate of 7.6%. As a percentage of cash ABR, approximately 83% of our fourth quarter investment activity came via sale-leaseback transactions, 57% was subject to master lease provisions and 90% are required to provide us with corporate and unit level financial reporting on a regular basis.
For the year ended 2018, we invested $516 million into 215 net lease properties at a weighted average cash cap rate of 7.6%, which compares to 2017 when we invested $534 million at a 7.7% weighted average cash cap rates. 82% of our 2018 investment activity involved direct sale-leaseback transactions, 65% was subject to master lease provisions and 96% are required to provide us with unit level reporting. We believe these statistics to speak to the quality, consistency and selectivity of our investment discipline and our long-standing industry and tenant relationships as 94% of our 2018 investments represent relationship-based investing activity from our senior management team.
From a tenant health perspective, our portfolio has strong weighted average rent coverage ratio of 2.8 times and approximately 74% of our cash ABR has rent coverage of two times or better. Based upon our historical data, a tenant with healthy rent coverage 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, only 1.6% of our leases that expire over the next 10 years have unit level coverage below 1.5 times. Similarly, only 0.7% of our tenants have an implied credit rating lower than BB minus per Moody's Analytics' tools and unit level coverage below 1.5 times. We believe this ongoing disclosure provides unique visibility into the health and profitability of the tenants that operate in our properties, which bolsters the predictability and security of our rental revenue.
Looking ahead, our quarter-end cash balance of $16 million and loan leverage of 5.2 times net debt to annualized adjusted EBITDA give us ample liquidity to capitalize on our growing investment pipeline well into 2019. We will continue to focus on investment opportunities that allow us to accretively deploy capital into small box, single tenant properties that are primarily originated through sale-leaseback transactions with master lease provisions and financial reporting requirements.
As we look out to the balance of 2019, we will maintain a strict adherence to our disciplined investment strategy, which reflects the many lessons learned over our collective 50 plus years managing and investing in single tenant net lease properties. In our view, we have one of the most durable and recession resistant portfolios in the net lease industry as we have freshly underwritten the properties and tenants in our portfolio and we have intentionally avoided those sectors that we believe to have less compelling industry and real estate fundamentals.
With that, I would like to turn the call over to Hillary Hai, our CFO, who will take you through the numbers. Hillary?
Thank you Pete and good morning everyone. Starting with the balance sheet. We ended the quarter with $1.4 billion of total assets, $515 million of debt related to our Master Trust Funding Program, $34 million outstanding on our $300 million unsecured revolving line of credit and $16 million in cash and restricted cash. Our net debt to annualized adjusted EBITDAre was 5.2 times at quarter-end which gives us capital capacity to continue to execute our external growth plans while managing within our targeted leverage range.
Turning to the income statement. Our fourth quarter net income was $8.3 million or $0.13 per share. NAREIT defined funds from operations or FFO was $17.4 million or $0.28 per share and adjusted funds from operation or AFFO was $17 million or $0.27 per share.
In terms of G&A, we continue to increase our operating efficiencies. And G&A for the fourth quarter was 13.6% of total revenues. We expect to see this metric to continue to decline as we largely have the infrastructure in place to execute our business plan.
Subsequent to quarter-end, we paid a dividend of $0.21 per share for the fourth quarter, which equates to a 78% payout ratio using our fourth quarter AFFO per share. Turning to guidance, we are reiterating our 2019 AFFO per share guidance range of $1.11 to $1.15.
Lastly, I wanted to highlight a couple of housekeeping items from the quarter. We received $211,000 of interest income from outstanding cash balances in the quarter which should materially decline next quarter as our cash balance normalizes. And two, the large increase in operating expenses was related to temporary increase in reimbursable expenses.
With that, I will turn the call over to Gregg.
Thank you Hillary. During the quarter, we invested $104 million in 24 transactions and 39 properties at a weighted average cap rate of 7.6%. The weighted average lease term of these properties was 16.6 years, the weighted average annual rent escalation was 1.5% and our average property size was $2.7 million. Consistent with our investment strategy, approximately 83% of our fourth quarter investments were originated through direct sale-leaseback transactions which are on our lease form with ongoing financial reporting requirements and master lease provisions in most cases.
This is a hallmark of our investment platform at Essential Properties. We seek to capitalize on our long-standing relationships in the net lease space to consistently source opportunities that fit our investment parameters and offer attractive risk-adjusted returns. To that end, 94% of our fourth quarter investment activity was relationship-based, which we define as transactions completed with operators, sponsors, advisors or brokers that senior management has done business with in the past.
From an industry perspective, restaurants remained our largest sector at 25% of cash ABR, with quick service restaurants or QSRs being our largest industry at 14.5%. Conversely, our casual and family dining concentration has declined 580 basis points year-over-year to 10.8% and our home furnishing concentration has declined 280 basis points year-over-year to 6.2%. We expect these trends to continue in 2019 as we see better risk-adjusted returns in other industries, such as early childhood education, medical and dental, entertainment and health and fitness.
From a tenant concentration perspective, Captain D's, a 500-plus unit QSR chain declined to 5% of cash ABR at year-end, which has been a goal of ours. Our top 10 tenants represented 33.1% of our cash ABR at year-end, which was down 200 basis points sequentially and down over 1,100 basis points year-over-year. We expect our top 10 concentration to continue to fall in the coming quarters as we grow our exposures with existing tenants, outside of our top 10 and capitalize on relationships with tenants that are new to our portfolio.
Looking at the portfolio more broadly. Over 91% of our cash ABR is derived from tenants that operate service oriented and experience based businesses, which has been a deliberate focus for Essential since we started investing nearly three years ago. We believe tenants in these industries and more importantly, real estate occupied by these tenants, are more recession resistant and heavily insulated against e-commerce pressures.
Moving on to asset management. Our portfolio remains healthy with a weighted average rent coverage of 2.8 times and approximately 74% of our cash ABR having a rent coverage ratio of two times or better. In addition, with 97.5% of our tenants required to report unit level financials to us, we have near real time transparency into the health of our tenancy, which is an important component of our active asset management approach.
From a lease expiration standpoint, just 3.1% of our cash ABR is coming due over the next four years and the vast majority of those expirations have coverage above 1.5 times. While our quarter-end occupancy was 100%, we would expect to see this ebb and flow in the coming years, as we manage through our near-term lease expiration schedule.
Turning to dispositions. With our average property value being $2 million, our portfolio is comprised of highly fungible granular properties that facilitate our re-leasing and disposition efforts. To that end, we sold eight properties during the quarter for $19.5 million in net proceeds. The cash cap rate on the seven leased properties that we sold was 6.9%.
Furthermore, since inception through year-end 2018, Essential has sold 71 leased properties for a weighted average cash cap rate of 6.6% and recognized at $13.1 million gain on sale. On a weighted average basis, these properties had a rent coverage ratio of 1.9 times, which compares favorably to our current portfolio coverage ratio of 2.8 times.
With that, I will turn it back to Pete for his concluding remarks.
Thanks Gregg and thanks Hillary. Our portfolio is in excellent shape with no vacancies, healthy coverage, coupled with complete transparency, good property level liquidity and limited near-term lease expirations. Our pipeline is full and we see a more stabilized operating and capital markets environment from which to invest. We are excited about the prospects for 2019 and we look forward to executing on the business plan that we articulated at the time of our IPO.
With that, operator, we will take our questions.
Thank you, ladies and gentlemen, the floor is now open for your questions. [Operator Instructions]. We will take our first question from Christy McElroy with Citi. Please go ahead. Your line is open.
Hi. Good morning everyone. Just in the context of your FFO and AFFO guidance for 2019. Can you give us a sense for sort of what you have embedded for acquisition activity? And how you are thinking about sort of bridging the funding gap between now and mid-year when you can put an ATM in place? I think you are at about 5.2 times leverage today. How comfortable do you feel pushing that to get more deals done?
Yes. Christy, thanks for the question and we look forward to seeing you early next week. We do not provide acquisition guidance in the context of our AFFO guidance intentionally. We certainly provide good disclosure around kind of where we have been historically and tend to point people to that. The last couple of years have been right around $500 million and we continue to invest.
We structured the IPO to give us enough runway to take us through our shelf eligibility which will come in early July and we have year-end, somewhere between $150 million to $200 million in capacity to continue to invest. And so we will continue to deploy capital if we see opportunities that are accretive and manage our leverage within our target and see what the market brings.
So I guess just more philosophically then, when you think about how far you are willing to push leverage and then with your stock trading at more of an NAV premium today, following the recent outperformance, does that give you more of a level of comfort in transacting?
Certainly. I think I have said in the past we would certainly be uncomfortable running through our leverage target without a concrete plan to kind of delever the balance sheet and equitize the balance sheet. And certainly we feel better about our stock price today than we did towards the end of last year and that certainly influences how we think about deploying capital.
Okay. Thank you so much. And we will see you in a few days.
Thank you Christy.
[Operator Instructions]. We will go next to Douglas Harter with Credit Suisse.
Hi. This is actually Sam Choe, on for Doug Harter. So Greg, I think you mentioned, I mean you talked about the top 10 tenant concentration and how you expect that to decline during the year. I mean, do you guys have a certain target as to how far you want to take that down?
Yes, Sam and this is Pete. We feel good at 33%. It's trended materially down and will continue to kind of ebb and flow. And as we scale the portfolio, it gives us more capacity to do slightly incrementally larger deals or do additional investments with tenants in our top 10. So we don't have a hard target around that top 10. We feel good at 33%. And I think just by continuing to invest, it will come down. But there is no hard target that we have articulated.
Got it. So I mean, a big theme for you guys is managing the concentration risk and I think you also mentioned that restaurants was a big part of the portfolio. So if there is no hard target on a certain sector as to how the exposure will trend, it's more about the investments that come in. Am I thinking about that right?
Yes. There isn't a hard target. Hard targets that we have articulated. We don't want any tenant to be above 5% and obviously at year-end, we kind of crusted that goal with Captain D's coming down to 5%. We have also articulated, we don't want to run any industries above 15%. And so you see QSRs and car washes and things like that, where we will moderate our investment activity to the extent that we are becoming over concentrated. And we certainly look at restaurants as kind of three distinct sectors with QSR, casual and family, having different real estate and economic drivers. But managing our diversity, both in terms of tenancy, industry and geography is important and it weighs into all of our investment considerations.
Great. Thank you so much.
You got it. Thank you Sam.
Next, we go to Ki Bin Kim with SunTrust. Please go ahead.
Hi. Good morning everyone.
Hi Kim.
Can you just talk broadly about what you are buying, your underwriting processes and basically how you go about due diligence when you are looking at new types of tenants for our new businesses?
Yes. I would say, predominantly in a lot of the stats that we provided, speak to kind of what we are looking at. We are focused on sale-leasebacks with 83% of our transactions in the fourth quarter being sale-leasebacks. We are focused on master leases with 57% of our leases being master leases, granular fungible real estate, all things that we have disclosed in the past.
And in terms of our industries, we were focused in 15 industries and with service based and experience based operations and the real estate in those industries and we kind of continue to invest across all of those sectors including entertainment, car wash, child care, restaurants.
In terms of our underwriting, it's really, we focus on the three critical risks factors in net lease investing, which are the corporate credit of our tenants, the unit level performance of our individual property and then the inherent real estate value and fungibility of the real estate and diligencing and underwriting along those three levels to make sure we are getting the appropriate risk-adjusted return.
And when you go into a newer business like education or early childhood education, I know you have done in the past in your career, but how do you get more comfortable around different operators and investing with which ones?
First, pure corporate credit, understanding how they are capitalized and what the corporate credit looks like. From an operating perspective, we tend to focus on sale-leasebacks and in the context of sale-leasebacks we get historical unit level performance such that the assets we are acquiring have operations that are proven and proven to work in the buildings we are in and proven to have the ability to support the rent obligations to us.
Lastly, I would point to the fact that over 90% of the business we are doing is with guys that we have done business with in the past and about half of that is tenants. And so, specifically in the early childhood sector, most of the guys we are working with are guys we have known for a while, we have had in our portfolios either here or in the past and we know them to be good operators and more importantly good tenants over the long-term.
And any particular reason why the master lease percentage for new deals have kind of ticked down in the past couple of quarters?
Yes. I think it's just the ebb and flow of the deals we are doing. It could be individual assets where we are doing a construction deal or a tenant that doesn't want to provide a master lease and we are not dogmatic in our approach to master lease and if we don't get it, it just changes the risk profile and we price that into the deal.
All right. Thank you.
Thanks Kim.
[Operator Instructions]. We will take our next question from Collin Mings with Raymond James. Your line is open, sir.
Thanks. Good morning everyone.
Good morning.
First question for me. It looks like you have acquired just shy about $38 million of properties here year-to-date. Can you maybe just share with us the pricing on those transactions?
The pricing on those is very consistent with where we were in 2018.
Okay. And then just during the quarter, can you maybe expand a little bit more on the move of VASA Fitness into your roster of top 10 tenants?
Yes. I think we have had two changes in our top 10 during the quarter. One is Town Sports which acquired Latitude Fitness, which was in our top 10. So that was not really a movement in, but just a name change and a credit change, if you will. And then the other operator was VASA Fitness and we have continued to invest with VASA and add properties on such that kind of populated them into the top 10. Great tenant, great operator and happy to have them in there.
Okay. And then can you expand upon what drove the just shy of what it appears to be about $1 million impairment during the quarter?
Hillary wants to tackle it.
Yes. So during the quarter, we impaired five sites. Three of those sites had near-term expiration and the other two sites we listed for sale below our book value.
Yes. And as you will see and as we have tried to articulate during the call, our disposition activity and our proactive asset management really focuses on selling risk out of the portfolio. So it's not surprising to see an impairment if we are selling one of the weaker assets in our portfolio.
Okay. No, it makes lot of sense. And then just on the relationship-based strategy overall, I mean in the press release, you noted that you were able to obtain unit level financial reporting on tenants that necessarily weren't required to provide that under the existing lease. Was that a one-time look? Is that something that you will be able to get adjusted in the lease going forward? And maybe just talk a little bit more about those opportunities, just given the relationship-based focus of the strategy, maybe to get unit level financials in situations where maybe others couldn't?
Yes. Listen, to the extent that there is asymmetrical information that we can capitalize on to make an investment, we will do that. We negotiate the right to get that on an ongoing basis. We can't be certain that we will come to agreement with the tenant, but certainly our relationships help in that regard. And it's not a huge part of our business, but doing business with relationships where we have good information creates value and we try to take advantage of those opportunities as we see them.
Okay. Thank you.
Thank you.
Our next question comes from Sheila McGrath with Evercore ISI. Please go ahead. Your line is open.
Hi. Yes, good morning. On the G&A front, I am wondering if fourth quarter is a good run rate? Or as you grow here pretty rapidly, are you having to hire additional asset managers and/or acquisition personnel?
Yes. I will let Hillary tackle it first.
So in terms of G&A, our cash G&A as a percentage of total revenues will decrease going forward but the nominal amount will increase. As you said, we will continue to hire more people as our portfolio grow.
Yes. I would say that certainly, it's going to grow more slowly than our assets and we should rationalize that. But by and large, the infrastructure and senior level professionals are baked into that G&A number.
Okay. Great. And then Pete, on the sales in the quarter, just curious how do you select the assets for sale? Were you selling vacancy or reducing concentration? How do you select the ones targeted for sale?
Yes. It's really a mix. We sold out our last vacant property. We try to get out of risk positions before they materialize. And that can be a long-term lease with declining coverage or near-term lease with an unlikely renewal prospect. And then lastly, given the predominance of our relationship investing, we have the opportunity to continue to invest with the tenants in our portfolio. So if we can sell exposure accretively to continue to invest in fresh sale-leasebacks, we will do that. And I think the sales in the fourth quarter represented all of those scenarios.
Okay. And last question on occupancy hitting 100%. Did you sell vacancy? Or were you successful in leasing-up some properties?
Yes. At the end of the third quarter, we only had one vacant property remaining and that was an asset that came to us vacant in our initial GE Seed Portfolio and then during the fourth quarter, we sold that asset.
Okay. Thank you.
Thank you Sheila.
[Operator Instructions]. We will go next to John Massocca with Ladenburg Thalmann.
Good morning.
Hi. Good morning John.
Just maybe kind of touching back on dispositions again and in kind of a broader context, I mean how much of the stuff you are selling roughly do you think comes from that legacy GE portfolio? I mean is that going to continue to maybe, because it's a little more of an older vintage than obviously the stuff you have bought since you have really kind of ramped operations, is that going to be more of the pool of things that you were using for disposition proceeds, if you will?
Yes. Well, globally, GE has become less and less of our portfolio and a smaller and smaller percentage. And I think it's below 20% as we see today. And so just naturally as we sell, it's going to be a smaller percentage. And whenever you buy a large portfolio, you have a higher percentage of capital recycling and asset dispositions that go along with that and buying seasoned assets and someone else's underwriting in a take-it-or-leave it deal. So I think initially, the largest part of our portfolio and the largest part of our sales were GE assets. As I look at the fourth quarter list here today, two of the eight assets were GE. And so as we go forward, I would imagine that more and more of what we are selling is just stuff we have bought organically through sale-leasebacks as opposed to GE assets.
Makes sense. And then one last little detail question. The entertainment kind of service sub-sector grew pretty decently in the quarter. I mean, what are you buying there? What are those types of assets? And is that a place where you might see more acquisition growth going forward?
Yes. We like the entertainment space. I believe, in the fourth quarter, it was a bowling alley deal we did as well as some trampoline parks. I think it will grow ratably. I don't see it growing disproportionately. The fourth quarter just happened to have a higher percentage. But I would expect the entertainment space to remain pretty static as a percentage of the overall portfolio.
And on a price per kind of transaction basis, I mean, is that kind of inline with what you do with the other stuff? Or is it maybe a little bit of a bigger box generally?
Yes. The entertainment space is going to be a bigger box. Certainly if you are comparing a 2,200 square foot QSR to 30,000 square foot bowling center, it's going to be a little bigger. And I think you see that in our average price per property across portfolio being $2 million and our average price per property invested during the quarter at $2.7 million.
All right. That's it from me. Thank you very much.
Thank you John.
[Operator Instructions]. And it appears that we have no signals from the audience. I will turn it back to our leadership team for any additional or closing remarks.
Well, thank you and thank you all for joining the call today. We were really proud of the quarter and the year that we posted and we look forward to 2019 and continuing to execute. And we look forward to the upcoming conferences and engaging with shareholders to continue the discussion. Thank you all.