Business Description
Essential Properties Realty Trust (EPRT) is a triple-net lease REIT that focuses on service-oriented and experience-based tenants with fungible and smaller-scale single-tenant properties. Along with sale-leaseback transactions to middle-market tenants, they form the core investment strategy of the company:
Its portfolio is diversified across tenants, although not quite diversified in terms of industries due to their focus:
EPRT differentiates itself by doing more sale-leasebacks (vs acquiring from the open market) with middle-market companies that allows the company to originate its own deals. The terms in the deals allow EPRT to enjoy (from High Yield Landlord's investment thesis on EPRT):
Higher cap rates: 7.5+% recently vs ~6.5% for other net lease REITs which focus more on investment grade tenants
Unit-level reporting: EPRT gets unit-level profitability reporting on most of its properties. EPRT mostly invests in profit centers which ensure the economics make sense for the tenants to stay in the properties. The average unit-level rent coverage is 4.1x.
Longer leases: 14 years versus around 9 years for most other net lease REITs
Master lease protection: master leases for multi-unit transactions prevents the tenants from closing one property and keeping the other ones open
Above average rent escalations: most other net lease REITs with investment-grade tenants only have 1-1.2% annual rent hikes, but EPRT's leases enjoy 1.5%
Ability to recycle capital accretively due to the higher cap rates EPRT get from originating their own deals with middle market companies
EPRT's prudent use of leverage also stands out from the pack. Its net debt to annualized adjusted EBITDAre was only 4.5x at 2023 Q3, and only 3.7x for pro forma that includes some unsettled forward equity. Other net-lease REITs often have net debt + preferred equity to EBITDA at 5x or above. 31% gross debt to undepreciated assets is also very low as well.
In its recent quarter, its dividend payout ratio is only 72% ($0.28 quarterly dividend and $0.39 AFFO after deduction from equity compensation expenses). This again shows the conservative capital allocation of the company.
When talking about EPRT, one inevitably has to talk about Store Capital (STOR), the only REIT Warren Buffett held close to 10% stake at some point but was acquired in 2022. EPRT was basically modeled after EPRT. They both focus on profit-center net lease properties that are occupied by middle market companies and it is originating its own deals via sale-and-leaseback transactions to create superior value for its shareholders. Given Store Capital is no long accessible in the public market, EPRT is a great alternative for people to invest a company that Warren Buffett would like as well.
Below are some quotes from the CEO, Pete Mavoides, which talk about EPRT's differentiation (from the interview with High Yield Landlord's author, Jussi Askola):
[asked: "when you joined Spirit in 2011, the company had a very large exposure to Shopko, which eventually went bankrupt and catalyzed Spirit’s transformation in 2017. How did that happen?"] "[T]hat was an investment the STORE guys made and was done before the company went public. When I left, having grown the portfolio and sold a lot of the Shopko assets, we had that exposure down to about 15%. We worked long and hard to materially reduce that exposure."
"[W]e very much focus on a middle-market sale-leaseback investment strategy, because the middle-market tenants give us the yields we look for, and the sale-leasebacks allow us to set the lease terms that we prefer. That is the fundamental business model that is consistent with STORE.
[asked: "EPRT has historically acquired properties at roughly 50 basis points lower than STORE’s acquisition cap rates. While the sale-leaseback market may not be perfectly efficient, do you think that the additional yield STORE gets in its investments indicates higher risk?"] "To zoom out to 30,000 feet, there are really three risk factors in net lease investing. One is the credit risk. What is the tenant, what is their implied credit rating, what are their cash flows, what is their access to the bond market or other sources of capital. That’s the credit risk.
Another is the lease risk. That is, what is the probability that the lease will be affirmed in bankruptcy or renewed upon expiration? What is the probability that the cash flows underwritten when the property is purchased continue indefinitely?
The third risk is the real estate risk. What is the fungibility and basis invested in the real estate such that, if you do have a credit bankruptcy and the lease is rejected, or the lease isn’t renewed upon expiration, what happens to your cash flows. What are the cash flows inherent in the real estate? Is it easy to replace the cash flows with another tenant? Is it a liquid asset? Will it be attractive for other buyers or users?
Our biggest focus at Essential Properties is that real estate risk. We focus on a much narrower set of industries than STORE with a more fungible and granular real estate asset such that our recoveries in the portfolio in a downside scenario are greater than what you’d see in the STORE portfolio. That fungibility and granularity manifests in an average individual asset value of $2.3 million and between 7,000-8,000 square feet.
Also, we are in 16 well-defined service and experience-based industries, whereas STORE is in 135 industries. So, we are able to be experts in our core set of industries and remain proficient in the fundamentals of those industries. Those industries have excellent real estate characteristics, with smaller, fungible buildings that can easily be adapted for other tenants or uses.
We believe this will result in greater recoveries in the downside scenario. Any net lease investing strategy, in the middle-market space in particular, you’re going to have credit events. And the goal is to minimize the damage suffered from those credit events.
What we experienced, Gregg Seibert and I, in managing the Spirit portfolio, was that when you take outsized risks on the real estate side with special use assets or big, chunky, 500,000 square foot industrial facilities in $20-30 million boxes, like steel mills and manufacturing plants - if you have special use assets like that, and you have a specialized user in place that goes out, your recovery can be 20 cents on the dollar versus 80-90 cents for a smaller, more fungible building.
So, when we sat down in 2016, we decided we don’t want to own any of that stuff, because that’s where you suffer outsized losses.""Our downside protection is not in a discount to replacement cost. It’s a discount to market rents. Particularly today when you’ve seen astronomical inflation, and construction costs have gone up so much. If you’re an operator, you want to find a vacant location or a dark box, and you’ve got those in every market across the country."
"We were recognized by NAREIT as having the best disclosure in the entire REIT industry. Every quarter, we disclose in our presentation and supplemental the gain or loss on our dispositions. What’s critical to that is that we have a differentiated, value-add investment model. We deliver capital to middle-market tenants wholesale, and then we are able to turn around and sell into the secondary market generally at a 100-basis point spread.
In other words, we can generate sale-leaseback cap rates at a 7% cap rate and immediately turn around and sell into the retail market at a 6% cap rate.""We use dispositions as a risk mitigation tool. We dispose of assets that just aren’t living up to our expectations. Now, if our cost of capital is out of whack, we can use this as a source of capital. But mostly we dispose of assets to minimize risk."
"I just don’t think movie theaters long-term are going to survive as they are, and I think to reposition their assets is going to be a problem because the operators are dealing with over-levered balance sheets"
"The industrial real estate we own is going to be granular, and I define that as a $3-10 million box. It’s going to be a 20,000 to 40,000 square foot building on a 5-10 acre parcel with industrial zoning. It’s a very fungible industrial use with plenty of storage, like equipment yards. Think of a John Deere dealership. It’s not going to be a giant manufacturing plant with a specialized use."
"Most of the acquisitions we are doing today, 80% or more, are with operators we’ve done deals with in the past, and that creates an anchoring effect where we’re anchored to previous terms. That’s a cap rate bias that helps us in a decreasing interest rate environment, but it cuts against us in a rising rate environment. So, we have moved up our cap rates 20-30 basis points since the beginning of the year, but it’s not one-for-one with interest rates."
"What drives our cap rates is (A) our perception of risk-adjusted returns, and (B) the competitive environment in which we invest. And given the rise in interest rates, we are experiencing more competition from some of our peers who would normally be chasing investment grade deals but can no longer make that work with their cost of capital, so they’re moving up the risk curve to the middle-market space."
"Generally, we’ve been around the 70% payout ratio range. We raise the dividend twice a year, in June and December. That’s been our policy, and it’s safe to assume we’ll continue along that trajectory."
In this interview, High Yield Landlord concluded with: "STORE was one of our favorite holdings because we thought that it had a clear path to deliver above-average returns with below-average risk. EPRT has that same path and this is why we are happy to have it as the largest holding of our Core Portfolio."
SWOT analysis
Strengths
Focused and differentiated strategy that allows the company to earn superior return than other net-lease REITs
Prudent capital allocation
High unit-level rent coverage to reduce risk
Weaknesses
Harder to scale
Opportunities
Getting new businesses from existing tenants
Threats
Other REITs replicating the strategy that competes with EPRT
References
2023/09 Investor presentation
2022/09/26 Interview With Pete Mavoides, CEO Of Essential Properties Realty Trust - Our Largest Position
2022/09/22 TRADE ALERT - Core Portfolio September 2022 (Incl. Update On STORE Capital)
Updates
2023/10/27 Valuation
First of all, one can easily see EPRT can earn 11% or higher in return on equity: cap rate + annual escalator = 9+%, that combined with the use of debt at 0.5 debt/equity ratio having about 300 basis points spread results in almost 2% more in return.
Annual rent escalation of 1.5% results in at least 2% AFFO growth, then at least 3% more from retained earnings. This is almost 5.5%. Then there is growth from capital recycling and potential equity issuance to acquire assets for accretive growth. For conservative sake, I use 5.5% as the sustainable annual growth.
EPRT, despite its potentially superior return than other net-lease REITs, still belongs to the category of companies with average return on equity. Using a discount rate of 11%, the fair price of the company is when the dividend yield is 5.5%. That is 1.12/0.05 = $20.36.
No comments:
Post a Comment