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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings. Welcome to the NETSTREIT Corp. Second Quarter 2023 Earnings Call. [Operator Instructions] Please note that this conference is being recorded.
At this time, I'll turn the conference over to Amy An with Investor Relations. Amy, you may now begin.
We thank you for joining us for NETSTREIT's Second Quarter 2023 Earnings Conference Call. In addition to the press release distributed yesterday after market close, we posted a supplemental package and an updated investor presentation. Both can be found in the Investor Relations section of the company's website at www.netstreit.com.
On today's call, management's remarks and answers to your questions may contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements address matters that are subject to risks and uncertainties and that may cause actual results to differ from those discussed today. For more information about these risk factors, we encourage you to review our Form 10-K for the year ended December 31, 2022, and our other SEC filings. All forward-looking statements are made as of the date hereof, and NETSTREIT assumes no obligation to update any forward-looking statements in the future.
In addition, certain financial information presented on this call includes non-GAAP financial measures. Please refer to our earnings release and supplemental package for definitions of our non-GAAP measures, reconciliations to the most comparable GAAP measure, and an explanation of why we believe such non-GAAP financial measures are useful to investors.
Today's conference call is hosted by Net Street's Chief Executive Officer, Mark Manheimer; and Chief Financial Officer, Dan Donlan. We will make some prepared remarks, and then we will open the call for your questions.
Now I'll turn the call over to Mark. Mark?
Good morning, everyone, and thank you for joining our call today. As detailed in our quarterly disclosure, we reported another solid quarter of investment activity with continued improvement in many of our key portfolio metrics. In addition, we recently completed a number of capital markets transactions that enhanced our balance sheet and strengthened our liquidity position, which Dan will cover in his section. All in all, our portfolio continues to perform at a high level, and our opportunities for external growth continue to increase in both size and quality, which has us highly optimistic about our ability to compound earnings and achieve attractive total returns for shareholders. .
Starting with the portfolio. As of quarter end, we had 531 investments that were leased to 87 tenants that operate within 25 retail industries across 45 states. With 82% of our portfolio, as measured by ABR, being leased attendance with investment-grade ratings and investment-grade profiles; and 87% coming from necessity-based discount or service-oriented retailers, we have not deviated from our focus on high-quality tenants in defensive retail categories. Our occupancy remained stable at 100% and our weighted average remaining lease term of 9.4 years was unchanged quarter-over-quarter.
In terms of near-term lease expiration risk. Based on our strong tenant relationships and the visibility we have into the performance of our properties, we are highly confident in the renewal prospects for the 2.5% of ABR that expires between now and the end of 2025. Coupled with the strong balance sheet and ample financial resources of our high-quality tenant base, we continue to believe our in-place cash flow stream should prove highly durable in any economic environment.
Turning to capital deployment. We closed on $115 million of net investment activity this quarter, which was primarily funded with the attractively priced equity capital that we raised in August 2022. Tenant quality remained high, as 81.3% of our second quarter investments were leased to investment-grade rated and investment-grade profile tenants. Our second quarter investments had an initial cash yield of 6.8% and a weighted average lease term of 11.6 years.
Of note, over half of our second quarter investment activity involved tri-party negotiations whereby the tenant agreed to extend out a large portion of their existing leases with NETSTREIT to 15 years, as well as add rent escalation clauses to the new and existing leases that were previously flat.
These IRR-accretive transactions, which modestly pressured cap rates in the quarter, not only enhanced our portfolio's internal rent growth profile, but also provided us with increased visibility into the desirability of our properties. We believe these collaborative industry relationships will drive additional opportunities for NETSTREIT as we look to become a greater part of the embedded solution for retailers and developers alike.
From a pricing perspective. While we believe cap rates have largely leveled off for assets that we pursue, we do expect third quarter investments to have slightly higher cap rates than this quarter despite there being no change in tenant quality.
Turning to dispositions. We sold 2 properties with 4.6 years of remaining lease term in the second quarter for $4.1 million at a 6.7% blended cash yield. In the back half of the year, we expect to see our disposition activity increase relative to the first half as we look to manage certain tenant concentrations. Of note, most of the planned disposition activity is being done to free up investment capacity with the same tenant, albeit at higher yields with better lease terms.
Looking at our investment pipeline. We are seeing increased opportunities for traditional fee simple acquisitions due to the impact of higher interest rates, a significantly less active 1031 marketplace and limited competition from highly levered buyers.
As we touched on earlier, we are seeing both retailers and developers consider our capital as an alternative financing option given the unattractive nature of the debt markets and/or the limited availability of financing from both small community and regional banks. While all of these market dynamics are resulting in more attractive cap rates, we're also seeing an increased willingness by retailers, especially those committed to growing their store count, to sign leases with longer lease terms and embedded rent escalations.
In addition, while loan origination opportunities remain plentiful, we have become even more selective in the types of loans that we may originate and how we allocate capital to these investments. In short, we are only focusing on those opportunities that can lead to sustainable long-term value from a relationship perspective and/or ultimately fee simple ownership.
In closing, we will continue to take advantage of our size and mine our unique sourcing channels for attractively priced opportunities to drive outsized risk-adjusted returns for shareholders. With $227.7 million of net investment activity closed in the first half of 2023, we remain ahead of pace, which gives us the confidence to increase our 2023 net investment activity guidance to at least $450 million from our prior guidance of $400 million.
With that, I'll hand the call over to Dan to go over our second quarter financial results.
Thank you, Mark, and good morning, everyone. Turning to our second quarter earnings. We reported a net loss of $792,000 or $0.01 per diluted share. Core FFO totaled $17.6 million for the quarter or $0.29 per diluted share, a 12% increase from the prior year period. AFFO totaled $18.7 million for the quarter or $0.30 per diluted share, a 7% increase from the prior period.
Turning to G&A. Total G&A expense, excluding onetime items, increased 4% year-over-year to $5.1 million, which was primarily due to a higher employee count. However, with total G&A representing 16% of total revenues in the second quarter versus 21.5% the year prior, we saw a considerable improvement in this ratio. Similarly, on a quarter-over-quarter basis, our cash G&A declined 1.6%. As we look out to the balance of the year and beyond, our G&A should continue to rationalize relative to our asset base and total revenues as the company has reached the proper scale to effectively operate our business on a go-forward basis.
Turning to the balance sheet. We had total debt outstanding of $489.4 million at quarter end, with a weighted average contractual interest rate, including the impact of fixed rate swaps, of 3.49%.
During the quarter, we amended and restated our $175 million senior unsecured term loan to extend the maturity to January 2027 from December 2024. All details are in our supplemental. Please note that we fully hedged this term loan using a combination of forward starting swaps that resulted in an all-in fixed rate of 1.37% through November 2023, which then adjusts to 3.12% through December 2024, with the final adjustment thereafter to 3.65% through the fully extended maturity of January 2027.
Additionally, and subsequent to quarter end, we closed on a new $250 million senior unsecured term loan with a delayed draw option, which has a fully extended maturity date of January 2029. The term loan includes an accordion feature that allows the company to increase the total loan amount to $400 million. At closing on July 3, we drew down $150 million and plan to draw the remaining $100 million in the first quarter of 2024. We fully hedged the $250 million term loan at an all-in fixed interest rate of 4.99% through January 2029.
As a result of these debt transactions, we no longer have any debt maturing until 2027, and our only exposure to variable rate debt is via our revolving line of credit, which has nothing outstanding as of today. We'd like to thank our banking partners for executing these transactions during what remains a tight lending environment. We also note that demand for both term loans far exceeded the principal balances raised, which we believe speaks to our ready access to efficiently priced capital.
At quarter end, our liquidity was $307 million, which includes $13 million of cash on hand and $294 million available on our revolving credit facility. However, when including the closing of our $250 million term loan in July, our pro forma liquidity increases to $557 million, which provides us with ample dry powder to meet our increased net investment target for 2023.
From a leverage perspective, our net debt to annualized adjusted EBITDAre was 4.6x at quarter end, which remains well within our targeted leverage range of 4.5 to 5.5x.
Turning to the dividend. On July 24, the Board declared a quarterly cash dividend of $0.205 per share, which represents a 2.5% increase versus the prior period and is our first increase in the company's dividend since our IPO. The dividend will be payable on September 15 to shareholders of record as of September 1. Based on this new dividend amount, our AFFO payout ratio for the second quarter was 68% and which we believe bodes well for future dividend increases.
Lastly, echoing Mark's sentiment, we have all the components in place to execute on our external growth plans, and to provide the best risk-adjusted returns to our shareholders. Therefore, we are updating our 2023 AFFO per share guidance to $1.20 to $1.23 and increasing the midpoint by $0.01.
With that, we will now open the line for questions. Operator?
[Operator Instructions] And our first question today comes from the line of Wes Golladay with Baird.
You mentioned you're building in higher escalators of some of the new deals. Is this something you've tried for in the past? Or is this something new that the tenants are more open to?
Yes. Now this is something that tenants are more open to, I think, out of necessity just with a 1031 market that's not nearly as active as it was, call it, 18 months ago. we've been able to negotiate those in any time that we're at the table negotiating directly with the tenant, we're trying to push for better escalators and it's always a challenge with more of an investment grade than investment-grade profile type focus where the leases tend to be flatter.
Okay. And then maybe your comment on dispositions. I want to make sure I understood it correctly. It sounded like you said you're going to do some, I guess, maybe asset management, maybe give a bit of the cycle, some of the bad or I guess, more riskier tenants. But then you also said you're going to sell some of the same tenant and go buy them. How should we look at the mix of what you're doing on the disposition front?
Yes. I think overall, similar to what we've done in the past, and that's -- we'll look at potential credit risks. We'll look at concentrations that can get a little bit higher with a smaller portfolio. And then as it relates to the second part of your question, that was kind of more directly related to tenants where we see a lot of opportunity with getting very attractive new leases and then cycling out of some of the shorter-term leases where we can sell those assets at or below the cap rates that we're acquiring the assets at.
Got it. And then maybe just 1 final one. Can you maybe talk about your tenant watch list now? I know you have a pretty high exposure to the IG or IG-like assets, but just maybe the balance of the portfolio?
Yes, sure. So I mean, we credit-score every single asset in the portfolio, and that's held up to be very strong. There are a couple of assets with one particular tenant that we may look to sell out of during the quarter. So I think you may see some exposure reduce, where there might be a little bit of risk, but feeling really good about the portfolio.
Our next question is from the line of Eric Wolfe with Citi.
It's actually Nick Joseph here with Eric. Maybe just on cap rates, it sounds like 3Q may be trending a bit higher than what you saw in 2Q with 6.8%. So I was hoping you could quantify that.
Yes, sure. I mean, I wouldn't expect to see a really big move. I mean, when you look at the fee simple acquisitions that we've done really since the fourth quarter of last year, they've been -- it's been pretty flat, kind of your 6.8%, 6.9%, up to maybe a 7% cap rate. I think we're likely to be at the high end of that in the third quarter.
And when you're at 6.9% or 7%, does that give sufficient kind of spread versus history in terms of investment spreads?
Yes. Nick, it's Dan Donlan. It does at these levels. We can definitely sufficiently raise accretive equity. And I think the magnitude of which we raise that capital is just ultimately depending on the sizing and pricing of the investment opportunities we see ahead of us.
And maybe just on that, when you talk about accretive equity. How are you thinking about that either relative to investment spread? Or is it -- it seems like in the second quarter, it was a bit below where Street NAV is. So how do you triangulate between that when making the decision?
Yes. I mean, look, we look at next 12 months AFFO yield, we look at run rate AFFO yield, and we look at implied cap rate when we think about raising equity. But as you -- as Mark alluded to in the quarter, we did have $90 million of well-priced capital from the August 2022 raise. And so we definitely achieved a nice spread, call it, 30, 40 basis points relative to our all-in equity that we pulled down this quarter. So going forward, spot cost equity continues to be favorable. So it's -- I think if you think about where we just raised the debt at 5%, we're looking at investment spreads kind of around 130, 120 basis points.
Next question is from the line of Todd Thomas with KeyBanc Capital Markets.
I just wanted to follow up a little bit on that discussion just around the investments that were completed in the quarter being funded with attractively priced equity that was sort of agreed to or issued on a forward basis almost 1 year ago. Your cost of capital is higher than it was last year. So I'm just curious how that might impact how you think about investments heading into 2024. -- as you work through sort of your dry powder during the balance of the year?
Yes. Look, I'll just kind of echo what I just said to Nick. Look, we're -- first off, we're at 4.6x leverage relative to our targeted range of 4.5 to 5.5x. So thankfully, we have dry powder to deploy. And as we think about our cost to equity, it's a spot cost of equity today. It is accretive. And we'll be judicious with how we raise capital. And I think that is effect from us going forward.
Okay. Are you able to share where you expect leverage to be at year-end, just given the increase in net investment activity that you're anticipating? And is there any additional equity capital raising activity or any capital raising activity embedded in the updated guidance?
Yes. Look, I think you should expect us to manage our leverage within the 4.5 to 5.5x range, which is consistent with what we provided in our guidance range.
Okay. And then just as we think about moving forward here, clearly, you have a sense around the pace of investments and the pipeline that you're working on. Just curious, just in the current environment, if you would expect the pace of investment activity to remain relatively steady from 2023 levels as we begin to think a little bit about 2024.
Yes, I think a little premature for us to start thinking about what we're going to do in 2024. It's been a pretty volatile market and need to understand kind of where our cost of capital is and what the market looks like and what our opportunity set is.
Looking at our opportunity set right now, it's as robust as we've seen. But we really only have visibility going out, call it, 75, 90 days out. So a little bit difficult to say what the opportunity set looks like in 2024 and kind of what the macro backdrop looks like. But yes, I mean, I think the general idea for the company is to continue to grow.
Next question is coming from the line of Ki Bin Kim with Truist Securities.
Dan, given the timing of the equity settlement towards the end of the quarter. How should we think about the cadence of earnings going into 3Q? Should there be a little bit of a dip before it comes back?
Look, I think the impact to earnings would really come from the term loan that we refinanced, that's going to be moving from 1.37% at the end of November of this year to 3.12%. And so I think that's really -- obviously, that's going to be dilutive as you think about kind of where we are. But I think there's plenty of offsets to that. And I think the idea around swapping the term loan and extending it out was to smooth out earnings growth between 2024 and 2023 and then 2025 versus 2024.
And could you just provide any kind of high-level color on Big Lots? I guess, what your plans are for that tenant, if you're looking to sell? And what potentially what kind of recovery ratio, what that looks like.
Yes, sure. So I mean, I think they did just do a sale leaseback, which is providing them a lot of liquidity for a period of time. So -- and I think they should be just about done with their promotional activity. I think we might have one more quarter of seeing margins kind of in the low 30s, which is lower than they've been historically. And so hopefully, they can kind of start to turn the corner after that.
But then kind of turning to the assets that we own. Predominantly very low rents, kind of around $7 a foot on average in kind of almost $10 market. So I feel like the real estate, we're pretty well covered with that. But there are buyers out there that are not your typical net lease buyers that are more focused on kind of a value-add type situation. So I think that can be very attractive for those types of buyers. And I wouldn't be too surprised to see us selectively decrease our exposure there.
Next question is from the line of Joshua Dennerlein with Bank of America.
This is Farrell Grant on behalf of Josh Dennerlein I was hoping you could give a little bit more color on your new term loan, specifically, maybe your rationale on the tenure and the extendability to the 5.5 years.
Yes. Look, the term loan market is an extremely attractive market right now relative to kind of the private placement and the unsecured bond market. and certainly at our size, call it, $1.7 billion, $1.8 billion in gross assets, it's a tool that we can utilize going forward.
As we think about debt raises in a year or beyond, the private placement market or the public unsecured bond market would then become more attractive as we'll get to the proper scale, which is basically $2 billion before you can start to access that market efficiently. So that's why we chose to go with what we did.
Our next question is from the line of Greg McGinniss with Scotiabank.
Just maybe briefly Touch on that term loan again real quick. So what was the thought process on issuing a new term loan versus maybe using the accordion feature on the other term loan that's already in place.
Yes. Look, I think we wanted to raise new capital 5.5 years and go out as long as we possibly could. So it's really the rationale around doing the 5.5 year.
So is the accordion still something that you think about tapping, or no?
The 5.5? I mean, look, it's -- I think it all just depends on where the market is, Greg. Thankfully for us, we have basically locked in our long-term debt needs through 2025. So to the degree that the opportunity set in front of us increases and the long-term rates remain pretty unfavorable, it could be something we'd look at. But I think, longer term, we'll want to match-fund our long-duration leases with longer-duration debt.
Okay. Switching gears a bit. Could you provide some color on maybe the discussions that you're having with merchant developers? And any interesting deal structures or cap rates you're negotiating there?
Yes, sure. I mean, I think that is certainly an area that's been under pressure. The community banks and smaller regional banks have much more limited ability to lend them attractive capital like they had in the past -- really for the past, call it, 10, 15 years. And then with a much shallower 1031 market, they need to rely on institutional capital.
So those conversations are ongoing, and it certainly has been a part of what we've done over the past couple of years and a larger chunk of what we've done over the past couple of quarters. And I think that's likely going to continue as long as retailers continue to want to grow and developers have that need for our capital.
Okay. And Sorry. So is there any sort of change in cap rate trends there that you can comment on?
I mean, I think overall, you've seen over the past -- since the Fed started increasing rates, 525 basis points 15 months ago, you've seen cap rates move up. And I think it's maybe moved up slightly more as it relates to the developers that were, at one point in time, able to get very aggressive cap rates from a 1031 market that's now essentially gone. But it's nothing more than maybe 150 basis points from the peak.
[Operator Instructions] Our next question is from the line of Nate Crossett with BNP.
So the lease escalation you talked about, I think it might be helpful if you just quantify what it is. Is it 0 to now 1%? What percent of the tenants are going to be kind of migrated over to lease escalation?
Yes. I think the retailers that we've worked with that are really trying to grow and feeling a little bit of the pressure to be in some institutional capital are likely to kind of need to adjust what their lease terms are, whether that be the tenor or the lease bumps. And what we've been able to get up to now has been, in some cases, 1% annually; and in some cases, 5% every 5; versus completely flat in the past. .
Okay. That's helpful. I don't know if you guys want to disclose what you've closed so far in 3Q. Maybe just like what does the pipeline look like in terms of loans versus acquisitions? And then if you can just maybe talk to like the difference in current pricing between doing a loan and straight acquisition.
Yes, sure. So yes, I mean, we don't usually get into what we've closed so far in the quarter. But that being said, the pipeline is very strong with a lot of opportunity out there. We're not as focused on adding loans to the portfolio. But as I said in the prepared remarks, we could consider adding some loans if that creates a path to some fee ownership of some assets that we really like at attractive pricing.
Okay. maybe just like a strategic question here, like investment-grade percent is incredibly high now. Like do you feel like that gives you more leeway to, I guess, do non-investment-grade stuff if the yield -- and get a little extra yield there? Or what's the thinking on that?
Yes. And we're probably a little bit less dogmatic about whether something is investment grade or investment-grade profile or if it's just a credit that we really like. So we have always added properties to the portfolio that we feel really good about the operator and feel like there's not a lot of risk. So not just looking at whether it's investment grade or not investment grade, but I would expect our investment-grade percentages to likely continue similar to what we've done in the past, if we're just looking at the forward pipeline.
We've reached the end of the question-and-answer session. And I'll turn the call over to Mark Manheimer for closing remarks.
Thanks, everyone, for joining the call today. We appreciate everybody's time.
This will conclude today's conference. You may disconnect your lines at this time. Thank you for your participation.