NetSTREIT Corp.

Greetings and welcome to the NetStreetCorp second quarter 2022 earnings conference call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kathy Korbulik, Investor Relations. Thank you, Kathy. You may begin.

We thank you for joining us for NetStreet's second quarter 2022 earnings conference call. In addition to the press release distributed yesterday after market closed, 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.netstreet.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 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 31st, 2021 and our other SEC filings. All forward-looking statements are made as of the day hereof and NetStreet assumes no obligation to update any forward-looking statements in the future. In addition, certain financial information presenting on this call includes non-GAAP financial measures. Please refer to our earnings release and supplemental package for definitions, GAAP reconciliations, and an explanation of why we believe such non-GAAP financial measures are useful to investors. Today's conference call is hosted by NetStreet's Chief Executive Officer, Mark Mannheimer, and Chief Financial Officer Andy Blocker. They 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 welcome to our second quarter 2022 earnings conference call. Before I discuss our investment activity for the quarter, I want to take a moment and say how pleased I am with the team's ability to consistently source attractive investment opportunities at strong yields and continue to be nimble and creative in a dynamic market. We have a unique and proven strategy, and our performance demonstrates our continued ability to execute and drive strong and steady results. With that, I am pleased to report that we completed $122.7 million of net investment activity for the quarter. In a market that is evolving rapidly with higher interest rates and macroeconomic uncertainty, we have remained disciplined and selective with the opportunities we pursue. As we started to see changes in the acquisitions market, we pivoted to higher quality and better priced acquisitions as shown by the higher yield for the quarter, which resulted in approximately $375,000 in debt deal cost in the quarter. We believe this was the right strategy as there was a clear economic benefit to being nimble in an evolving market. Since our IPO less than two years ago, we have more than doubled our portfolio size from 163 properties to 381 properties. our ABR from $34.5 million to $84.2 million, and enhanced our diversification metrics, while maintaining the highest credit quality and stable portfolio in the net lease space, increasing investment grade and investment grade profile tenancy about 900 basis points to 81%. Our portfolio is largely made up of tenants in the necessity, discount, and service industries, all of which are well insulated from recessionary and or inflationary pressures. Despite uncertainty in the current economic environment, we believe that the defensive nature of our portfolio will allow us to continue to outperform as we did during the COVID pandemic, where we were the only public net lease retail REIT to collect 100% of our pre-COVID rents. In addition, we have a strong balance sheet with ample flexibility and liquidity to meet our investment goals for the year. Now turning to our investment activities for the second quarter, we acquired 22 properties for $117 million at a weighted average initial cash capitalization rate of 6.7% with a weighted average lease term of 10.9 years. It is important to note that our second quarter acquisitions were on average at a higher going-in cap rate, better credit, and with a longer lease term than prior quarters, which really demonstrates the strength of our team and ability to adapt and source high-quality opportunities in an evolving market. Rent commenced on three development projects that had total cost of $9.8 million at a weighted average investment yield of 6.5% and a lease term of 10.3 years. During the quarter, we entered into a $6 million convertible loan with a 12-month term and an interest rate of 6.5%. We expect this loan to be converted into fee-simple ownership of two properties by the end of 2022 with a cash cap rate in line with the current interest rate. Additionally, we sold a Kohl's for $9.9 million at a 6% cap rate. And we terminated the lease with a small auto parts retail store and sold the property. We expect to collect the remaining lease payments in a lump sum, which should result in a small gain in a future period. Finally, we provided $4.6 million of funding to support ongoing development projects. At quarter end, we had six projects under development where we have invested $12.8 million to date. You'll notice our development activity is down from prior quarters due to recent completions, and we have taken a more cautious approach as we expect a more challenging environment for developers to perform within their previously negotiated construction budgets with tenants, given rising construction costs, rising labor costs, and economic uncertainty. At quarter end, our portfolio is comprised of 381 properties with 75 tenants, contributing approximately $84.2 million of annualized base rent. The portfolio had a weighted average lease term remaining of 9.5 years, with 81% of ABR represented by tenants with investment grade ratings or investment grade profiles, and the portfolio remains 100% occupied. We added four new tenants in the quarter, which includes a Sprouts grocery store with solar panels on its roof, augmenting our ESG efforts, an Ulta store, a Moe's restaurant, and an NTB automotive service store. Subsequent to quarter end, we acquired seven properties for $45.4 million, including closing costs. With the recent acquisitions, we've completed $304 million in net investment activity year-to-date, which is over 60% of our full-year $500 million targeted net investment activity. This level of activity is a testament to the experienced team we have in place and our focus to grow the portfolio with high-quality tenants. We believe we are well-positioned to maintain our momentum for the remainder of the year and beyond. With that, I'll turn the call over to Andy to go over our second quarter financial results and 2022 guidance.

Thank you, Mark. And once again, thank you all for joining us on today's call. In our earnings release published yesterday after market close, we reported net income of $0.04, core FFO of $0.26, and AFFO of $0.28 per diluted share for the second quarter. The portfolio's annualized base rent grew to over $84 million in the second quarter, up 52% from June 30, 2021, driven by 114 acquisitions, seven developments, and two mortgage loan receivables since the end of the prior year's second quarter. Interest expense increased $600,000 to $1.5 million from $900,000 in second quarter 2021, due principally to our higher average balance outstanding on the revolver and increased base rates compared to second quarter 2021. G&A increased to $4.9 million in the second quarter compared to $4 million from second quarter 2021, primarily due to an increase in the number of employees from 24 to 30 to support our growing portfolio. In addition, as Mark referenced, we had approximately $375,000 of dead deal costs in the quarter, but we do not expect this increased level of dead deal costs in the future quarters. Turning to our balance sheet, at quarter end, we had over $39 million in escrow to facilitate acquisitions that closed on July 1st, and total debt of $412 million outstanding. of which $175 million is from our fully hedged term loan with a remaining balance from our revolving line of credit. We launched a recast of our credit facility on July 11th to expand our revolver from $250 million to $400 million and to add a $200 million long five-year term loan to our debt structure. The new term loan is expected to be freely prepayable at any time providing optionality to access the private placement market or to seek other capital markets alternatives for refinancing if we see attractive longer-term opportunities. The $600 million recast is already fully committed and is expected to close in mid-August, at which time our liquidity will increase by $350 million. We intend to leave our existing $175 million terminal in outstanding, which has a fixed all-in rate of 1.36%, and matures in December 2024. On June 23rd, we settled 2.4 million shares, receiving net proceeds of $50 million under our forward sales agreement associated with our January offering. We have until January 10th, 2023 to settle the remaining 4.5 million shares associated with our forward sales agreement. During the quarter, we did not make any sales under our ATM program. At June 30th, 2022, Our net debt to annualized adjusted EBITDA ratio was 3.7 times after giving consideration to the remaining shares outstanding under the forward sales agreement from our January offering, well below our target range of 4.5 to 5.5 times. With regard to our dividend, earlier this week, the Board declared a 20-cent regular quarterly cash dividend to be payable on September 15th to shareholders of record as of September 1st. Our payout ratio for the quarter was 71%. For 2022 AFFO per share guidance, we're maintaining our previous guidance range at $1.14 to $1.17, but due to market volatility, have widened some of the expectations and our underlying assumptions. Our guidance includes the following assumptions. Investment activity in the year, including developments where rent has commenced and mortgage loan receivables, net of dispositions to remain at least $500 million. Cash G&A is expected to remain in the range of 14.5 million to 15 million, which is inclusive of transaction costs. Non-cash compensation expense is expected to remain in the range of 5 to 5.5 million. Due to a combination of increased borrowings and a significant increase in the forward curve since we most recently provided guidance, our cash interest expense expectation has been increased and widened from our previously stated 5.5 to 6.5 million dollars to $7 to $9 million. Non-cash deferred financing fee amortization, which is not included in our cash interest expense, is increased from $600,000 to the range of $800,000 to $900,000 to reflect the pending credit facility recast. And lastly, a decrease to full year 2022 diluted weighted average shares outstanding, which includes the impact of OP units from our previously stated 52 to 54 million shares to now be in the range of 50 to 52 million shares as a result of higher projected debt balances for the remainder of 2022. These changes will not impact our target leverage as we continue to expect our net debt to EBITDA to be between 4.5 to 5.5 times. To wrap up, we're confident in the ability of our portfolio to offer stable and predictable cash flow during a time of economic uncertainty, and we appreciate the support of our bank group, as we finalized our largest round of debt financing. During our tenure as a public company, we have demonstrated our ability to execute and build our best-in-class portfolio. Our team remains focused and diligent as we look forward to meeting our investment goals for the remainder of the year. With that, we will now open the line for questions. Operator?

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. The confirmation tone will indicate that your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions.

Thank you. Our first question is from Todd Thomas with KeyBank Capital Markets.

Please proceed with your question.

Hi, good morning. First question, in terms of funding investments throughout the balance of the year, you know, you have the remaining shares to settle from the forward equity in January. And Andy, you just discussed, you know, a little bit of the, in the revised guidance, you know, your expectation for the weighted average shares. But I was just wondering if you could just talk about plans to permanently finance the line balance from here and also discuss thoughts on raising equity capital in the back half of the year as you look towards the $500 million net investment guidance that you maintained?

Yeah, thanks, Todd. Yeah, so from our perspective, you know, we're taking a big step by, you know, funding the line balance with the recast that we just talked about. You know, that's a $600 million recast where we stand right now. We've got about $900 million of current in-place commitments. We're waiting on another $170 million more. We'd anticipate that that would close in the next couple weeks, but it is fully committed. You know, that's, like I said, it's a long five-year, a new long five-year term loan that goes along with the existing term loans that comes to maturity, you know, at the end of 2024. So we feel like From a debt perspective, we're pretty locked up and we're adding, as I said in my remarks, we're adding another $350 million worth of debt liquidity to the balance sheet. On the equity side, yeah, we've got $95 million roughly of equity that remains undrawn under the forward. On the leverage and lowering the share count expectation, The real key there is we just wanted to get greater certainty on the debt financing before we decided to be more efficient on the funding mix. So if you recall, we started off the year, we were talking about a private placement. The private placement market closed very, very quickly. That's when we moved to the debt market. And we're really thankful for the support that we have. We still have access to, I think it's roughly $160 million worth of equity through the ATM. and just feel very confident with where we stand as we look out at the opportunities that Mark and his team is looking at on the asset side.

Okay. Does the current budget have any additional equity capital being raised throughout the balance of the year? It looks like you'd be in sort of the high five times range on a net debt to EBITDA basis, pro forma, the remaining $250 million of of acquisitions or so. You mentioned the four and a half to five and a half times target leverage level. I realize you've been below that by a wide margin for many quarters and may bounce around a little bit above that in the near term, but where would you expect to be at year end?

Yeah, I would think that we'd probably be at more efficient leverage, probably around And, you know, like I said, you know, we're never going to talk about, you know, specifically, you know, the specific methods that we have available to us. But, you know, we have not been active on the ATM, and we do have that as a tool at our disposal, you know, to take advantage on a go-forward basis.

Okay. And then in terms of asset pricing and acquisition cap rates, I was just curious if you could talk about pricing trends whether you are seeing cap rates widen a bit as buyers and sellers begin to adjust to the higher interest rate environment and sort of what you're seeing in the pipeline today.

Yeah, absolutely. So yeah, I mean, you saw a pretty big pivot from us early on in the quarter, which resulted in a little bit of dead deal costs, which we always like to try to avoid. But the increase in pricing was just a lot of the typical buyers falling out of the market. I think a lot of the 1031 buyers that use leverage, the ones that were locked in an exchange needed to close on those transactions. But once those kind of really flowed through the market, we've really seen less activity with 1031 buyers. They're still there, but any of them that use a decent amount of leverage are not going to be, we don't anticipate being as active. And then certainly the larger private equity firms that are using a lot of leverage are more or less completely out of the market. And so You know, we pivoted during the quarter, and I think, you know, shouldn't be lost on everybody that not only did we get a, you know, 6.7% cash cap rate on acquisitions, but then when you look at the quality of what we acquired during the quarter, you know, from a credit standpoint, you know, weighted average lease term, et cetera, we were really excited about the opportunities that we saw during the quarter, which is why we pivoted. And so, you know, certainly in my view, our highest quality acquisition portfolio acquisitions during the quarter. So we hope that continues to be the case, but I think certainly we've seen in the neighborhood of 25 basis points on average increase in the areas that we're looking for.

Okay, great. And one last one. Andy, if I could just go back to the recast and the term loan. Is the term loan fixed or variable, and do you plan to put hedges in place?

Yeah, I mean, so, you know, that's, you know, when we talk about, you know, the interest expense guidance expectations, you know, the SOFR, you know, the forward surfer curve has just been, like, literally all over the place, right? You know, we had shown, you know, a rate, you know, to our board recently, and, you know, the current market is, you know, well inside of that. So, we're going to evaluate, you know, I think our Our thought at this point is while it has a delayed draw feature, we would likely fully draw it down at closing. And then the question is going to be, what does the forward curve look like at that point? And how do we think about, you know, fixing that, you know, in either, you know, in full or in part based on market conditions at that point in time? But, you know, like, you know, With the Fed, you know, increase in rates by 75 basis points. With the GDP read, you know, yesterday, I think that you've seen a little bit better forward curve, you know, recently than we had seen, you know, not but like a week or two ago, right? So that's an evaluation that we'll make, and it will certainly make you aware of that at that point in time.

Okay, great. All right, thank you.

Thank you. Our next question is from Nicholas Joseph with Citi. Please proceed with your question.

Hey, it's Chris McCurry with Nick Joseph. Are you seeing any, I just want to follow back up on the transaction markets. Are you seeing any buyers pull out of certain markets more so than other markets? And has there been differences in buyer appetite across different qualities, across the quality spectrum for different assets?

Yeah, no, it's a, it's a good question. I, you know, I think, you know, really where we started to see, um, more buyers pull out, it really had to do with more of the leverage buyers at lower cap rates. So, you know, the higher quality transactions that were, you know, in many cases, well below the cap rates that were acquiring assets at, uh, you know, a lot of those deals started, uh, you know, we started to get a lot more calls, uh, on those types of transactions as you know, kind of your lower four cap rate range, uh, you know, transactions. people relying on debt, you start getting to negative leverage a lot more quickly on those types of transactions. So as you start moving up the cap rate scale, that started to creep in more and more as interest rates continued to rise. So I think it's really been much more the buyer that's relying on leverage. You saw it really in industrial, which were not really active there at all, which had lower cap rates. You've seen like Amazon's Distribution center is kind of, you know, that we're trading in the threes kind of trading at the end, kind of the higher four is up to a five cap. So really pretty big, um, you know, displacement in that market. Uh, and then as you start creeping up into, uh, retail and some of the lower cap rate deals, uh, just the debt doesn't pencil for the, for the higher leverage buyer. So that's really where we've seen, uh, you know, the biggest impact. And so we've certainly just seen a massive increase in our opportunity set, which allowed us to be significantly more selective. on the quality as well as on pricing this particular quarter. And we're seeing that into the third quarter. So we're pretty excited about what we're seeing in the third quarter as well.

Got it. And then with the tougher macro backdrop today, how are you guys thinking about the watch list? Are there any tenants on the watch list that maybe you're keeping a closer eye on? Or how has the watch list evolved?

Yeah, sure. Yeah, and it's pretty similar to what we were starting to see last quarter as it relates to the consumer, especially on the lower end. They're really starting to get under more and more pressure. Savings for the consumer are back to pre-pandemic levels. You're starting to see consumers rely more on credit cards. And Walmart and Target results, I think, illustrate necessity products are selling and discretionary is not. So we took a pretty deep dive into our portfolio, feel really good about the defensive nature about what's in our portfolio. I think if we have One tenant in particular that I think has seen pretty poor results most recently, that'd be Best Buy. They've had a bit of a rough year. It's really just the health and the preferences of the consumer have shifted, but their sales are above pre-pandemic levels. And we're very confident in the tenant's resilience and the assets that we own, so we don't feel like there's any risk to the rent or anything like that. But I think we need to be pretty cautious on that particular tenant. But, you know, I think we do a pretty good job of underwriting not only in the tenant health, but the cyclicality and predictability of tenant health in various different economic environments. And, you know, we certainly have a pretty volatile market out there. And then I think we also do a pretty good job of applying, you know, an appropriate asset management plan after we acquire the assets, you know, if you recall last year. We sold an RV asset that was kind of at the peak of its cyclicality, doing extraordinarily well last year. You're starting to see Keystone and Winnebago in the news with not-so-positive news, so we're really happy that we moved out of that asset last year. So I think that speaks to how we're thinking about when we can opportunistically move out of certain assets and really trying to focus on assets that we feel like are going to do very well in any economic environment.

Thank you.

Thank you. As a reminder, if you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. Our next question comes from Connor Saversky with Barenburg. Please proceed with your question.

Hi out there. Thanks for having me on the call. Just quickly on the development pipeline, notice the spend this quarter was around $5 million. And again, in the context of kind of these heightened risk factors and maybe seeing some of your developers pulling back from activities, can you provide any expectation for what that run rate spend might look like through the end of the year and possibly into 2023?

Yeah, sure. I mean, it's going to be pretty dependent on what's going on with construction costs, labor costs, et cetera. So a typical development deal for us is where we're partnering with a developer. They cut a deal with, you know, they've got their construction budget and they've got, you know, whatever they paid for the land or whatever they've signed up to, you know, got the land under contract for. And then they negotiate what the rent's going to be with the tenant. And that kind of locks in what their yield should be and what they can flip the asset at. And so, we've been very active in having conversations with the developers that we work with, and they're really just getting squeezed. So the construction costs being higher, labor costs being higher, as well as more difficulty even really getting labor. So seeing the pressure that they're under and knowing that the tenants are typically not willing to renegotiate the rents that they've agreed to, we don't want to be put in a situation where the developer's coming back to us and asking us to take the pain. So We just see a lot of opportunity in other areas right now where we think it's prudent for us to kind of take a step back and really see how that plays out and take a cautious approach, especially in an environment where we have ample acquisitions opportunities.

Got it. Understood. And then maybe just a bit of a modeling question on the 26 investments completed during the quarter. Can you give us any sense of time waiting as to when those 26 were completed?

Yeah, Connor, I think that our, you know, from bringing them onto the portfolio, I think we had an average of about 20 days.

Sorry, say that one more time. 20 days, and that was somewhat influenced by early in the quarter where we started to see cap rates start to move and seeing better opportunities where we, you know, pushed back on some other transactions. Anything that we saw in diligence, we pushed back pretty aggressively on some of the sellers, and so We ended up with more of a back-end weighted, you know, quarter, which I think will likely reverse itself in the third quarter.

Yeah, and kind of just recall, I mean, we obviously, we closed, you know, roughly $40 million on the first day of the quarter, right, in the third quarter. So we're well ahead of that.

Okay. So for the second quarter, we're looking at, just for clarification, 20 days after March 30th or 20 days before June 30th? Yeah, 20 days before.

Yeah, 20 days average outstanding is the way that I think about it. Got it.

Okay, thank you. That's all from me.

Thank you. Our next question is from Josh Dennerlein with Bank of America. Please proceed with your question.

Hello, this is Dan Gunn on behalf of Josh Dennerlein. I was hoping to see if you could elaborate more on where you see the best opportunities for capital recycling within the portfolio.

Yeah, sure. I mean, we're always kind of taking a look at the portfolio where we see potential risk. You know, fortunately, we took such a deep knife to the portfolio before going public that there, you know, really isn't much, if anything, that, you know, that has, you know, there's any concern. Now, that being said, you know, we do keep relationships with various other counterparties in the marketplace, whether they be DST operators or you know, 1031 buyers or even brokers that have some relationships where somebody may, you know, find themselves in a trade and need to close on something quickly. So, you know, we'll take advantage of those types of opportunities and sell assets here and there. I think, you know, like our 7-Elevens and some other assets within the portfolio, oftentimes, you know, we get pretty aggressive offers on those, you know, sub five cap range. And so, you know, in the event that we can sell some of those assets and, you know, at pretty aggressive cap rates and we feel like we can redeploy the capital efficiently and accretively, you know, we're always willing to do that. But, you know, we also don't want to, you know, be out the market, you know, selling $50, $60 million and not be able to replace it in the quarter because that, you know, that puts some pressure on earnings.

Great.

Thank you.

And then also, could you, like... Could you also remind us of what the mix between the fixed rent bumps and inflation-linked bumps within your portfolio as well?

Yeah, sure. I mean, you know, we have a few assets in the portfolio that have CPI bumps, but, you know, I think oftentimes people think of that as inflation protection. But the reality is almost all of the CPI rent bumps in the net lease retail space are you know, three times CPI, you know, the lesser of three times CPI or 2% or 1% or whatever the transaction is, you know, depending on how that lease is structured. We would rather just have one or 2% fixed rate bumps for the periods of time where there isn't inflation to make sure that we're getting the maximum rent growth. So, you know, having a few leases in the portfolio with CPI, you know, with caps, we kind of view those as inferior to the fixed rate bumps. But, maybe two-thirds of the portfolio has some level of rental increases.

Thank you. Thank you.

Our next question is from Connor Saversky with Barenburg. Please proceed with your question.

Just one more from me here. I'm just looking at the provision for impairment recognized in Q2. Was that related at all to any assets that were maybe slated for sale and then moved back onto your operating portfolio once mark to market?

Yeah, we kind of had a kind of odd situation related to the advanced auto parts store that we sold in the quarter where we terminated the lease and then sold the property during the quarter. And then we're expecting to get a lump sum of the remaining lease payments in the third quarter. Just that timing led to what would be an impairment and then likely a gain after that or some revenue that is a little bit unusual. But all in all, if you put all those pieces together, it actually would result in a slight gain. So it's just a little bit of a funky accounting scenario. Got it. Can you quantify what that gain would be at all? I mean, we're talking about $100,000 or something like that, so pretty minimal.

Okay. Understood. Thank you.

Thank you. There are no further questions at this time. I would like to turn the floor back over to Mark Mannheimer for any closing comments.

Well, thanks, everybody, for joining us today, and we certainly look forward to continuing the dialogue in the future. Take care.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.