Spirit Realty Capital, Inc.

Good day and welcome to Spirality Capital Third Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. If you need assistance, please signal Conference Specialist by pressing the star key followed by zero. After today's presentation will be an opportunity to ask questions. Please note that this event is being recorded.

Now I'd like to turn the conference over to Mr. Pierre Riveau. Senior Vice President of Corporate Finance.

Please go ahead, sir. Thank you, operator. And thanks, everyone, for joining us for SPIRIT's third quarter 2022 earnings call. Presenting in today's call will be President and Chief Executive Officer Jackson Shea and Chief Financial Officer Michael Hughes. Our Chief Investment Officer Ken Heimlich will be available for Q&A. Before we get started, I would like to remind everyone that this presentation contains forward-looking statements. Although we believe these forward-looking statements are based on reasonable assumptions, they are subject to known and unknown risk and uncertainties that can cause actual results to differ materially from those currently anticipated due to a number of factors. I refer you to the Safe Harbor Statement in our most recent filings with the SEC for a detailed discussion of the risk factors relating to these forward-looking statements. This presentation also contains certain non-GAAP measures. Reconciliation of non-GAAP financial measures, the most directly comparable GAAP measures, are included in the exhibits furnished to the SEC under Form 8K, which include our earnings release and supplemental investor presentation. These materials are also available on the investor relations page of our website. For our prepared remarks, I'm now pleased to introduce Jackson Shea. Jackson.

Thanks, Pierre, and good morning, everyone. Our third quarter results continue to demonstrate the validity of our underwriting approach, highlighted by low lost rent, stable property cost leakage, and occupancy over 99%. Our portfolio benefits from diversification across 346 tenants operating within 34 industries and 12 distinct sub-asset types, allowing us to produce a reliable, stream of cash flow for our shareholders, and once again, increase our quarterly common dividend. During the quarter, we invested $268 million in capital expenditures at a weighted average cash capitalization rate of 6.86 percent, a 49 basis point increase over last quarter, and a 133 basis point spread to the capital we raised to fund this capital deployment. Our capital deployment included 51 properties, which have approximately 15 years of weighted average lease term, average annual escalators of 1.8%, and a weighted average economic yield of 7.76%. These acquisitions consisted of 46% industrial and 54% retail and other. I'm pleased to announce that our other bucket, was our first add-on acquisition with Invited, formerly Club Corp, since our initial transaction last year. We partially funded these acquisitions with $74 million of disposition proceeds, predominantly from the sale of leased retail assets with a weighted average cash capitalization rate of 5.7%, resulting in net capital deployment of $194 million at a blended cash yield of 7.29%. We sold five QSRs and a Gardner School in the low five-cap area, two MAC Paper properties in the high four-cap area, and two Smart and Final Grocery Stores, formerly Hagen Properties, in the low six-cap area. As you will notice, the percentage of industrial acquisitions rose meaningfully since last quarter. from 18% to 46%. And I anticipate that percentage to rise materially higher in the fourth quarter, as the industrial segment is where we are seeing attractive sale-leaseback opportunities with new and existing customers. Many of our customers that operate light manufacturing, distribution, and IOS facilities need funding to meet their growth objectives. And with other forms of corporate financing becoming less available or attractive, sale leasebacks as a financing alternative are becoming a more attractive option. Despite this favorable dynamic, we are being highly disciplined and selective in our pursuit of opportunities. And we believe pricing for these assets could become more attractive in the near to medium term. To help fund these opportunities, we continue to pursue prudent asset recycling by disposing of smaller retail assets where cap rates have proven stickier. This form of capital recycling will also help shape our portfolio as we dispose of retail properties and redeploy proceeds into the industrial segment under new long-term sale leasebacks and current market terms with tenants who need our capital now. Finally, As we approach the end of 2022, I reflect on the goals we set three years ago at our investor day, including ABR, non-retail exposure, and AFFO per share. As we sit here today, I want to highlight that we are ahead of our investor day ABR goal by 61 million. Our industrial exposure is over 20% and growing, and the midpoint of our AFFO per share guidance is 14 cents higher than our original 2022 target. Looking back even further, since the spinoff of SMTA in 2018, we have increased our ABR by 82% to 661 million, grown our industrial rents by 108 million, increased our WALT to 10.4 years, and raised our public tenant exposure to 53%. Over the same period, We have meaningfully improved our balance sheet, liquidity, internal processes, and technology systems. And with this strong foundation, our portfolio and platform are well equipped to perform, take advantage of the opportunities we are seeing today, and increase shareholder value over time. With that, I'll turn the call over to Mike.

Thanks, Jackson. During the third quarter, our annualized base rent increased $13.8 million to $661 million. with $12.8 million driven by net acquisitions and $1 million from organic rent growth. We received $1.2 million of rent from the seven theaters released in 2020 and 2021, representing 87% of their stabilized rent. As of October, only three theaters remain under variable rent arrangements, as the rest have fully reverted to base rent. Other operating income was elevated this quarter to $2 million, which included approximately $1.5 million in non-recurring income predominantly from a government taking for a highway expansion. On the expense side, cash interest increased $3.3 million from last quarter, with approximately $2.8 million driven by a 145 basis point increase in the weighted average interest rate on our bank debt. During the quarter, we issued 1.1 million shares of common stock to settle existing outstanding forward contracts and issued an additional 2.2 million shares through our ATMs. generating $141.9 million in net proceeds at an effective price of $42.72 per share. Additionally, we again raised our quarterly dividend to $66.3 per share, representing an annual growth rate of 3.9%, while maintaining our AFO per share payout ratio of 75%. After locking in $800 million in term loans during the quarter and effectively fixing their payments through well-timed interest rate swaps, we had no floating rate debt outstanding at quarter end. Subsequent to quarter end, we received commitments for a 500 million, two and a half year delayed draw term loan facility, which will allow funds to be drawn up to July 2nd, 2023, and will mature on June 16th, 2025. This new facility provides us with significant debt capacity to pursue attractive acquisition opportunities, allows us to be patient when determining when to access the unsecured bond market, and further demonstrates the strength of our banking relationships. We ended the quarter with $1.3 billion of liquidity, consisting of $1.2 billion in revolver capacity and $110 million of cash, which will further be enhanced by the new turn-on facility that we expect to close in the coming weeks. Turning to guidance, we are narrowing our AFO per share range to $3.55 to $3.57, increasing our midpoint by a penny, which represents growth of 9.5% from the prior year. We were maintaining our capital deployment target of approximately $1.5 billion and narrowing our disposition range to $250 to $300 million. When we announced our 2022 guidance on January 10th, inflation fears were much lower. The U.S. 10-year Treasury yield was 1.75%, one-month SOFR was 0.05%, and our stock was trading at $48 per share. Despite these significant changes in the macro landscape and our cost of capital since that time, our portfolio strength, capital allocation strategy, and ability to timely source various forms of well-priced capital has allowed us to perform in line with the aggressive expectations we laid out in January and raise our quarterly dividend for the second consecutive year. We remain well-capitalized and positioned to take advantage of future opportunities. With that, I will turn the call back over to the operator to open it up for Q&A. Operator?

Thank you. Now I'll begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two.

This time we'll pause momentarily to assemble the roster. First question comes from Anthony Bellone, JP Morgan.

Please go ahead.

Thank you, and good morning. Can you talk about just the ability to continue recycling capital the way you have been pretty accretively, just how deep that pool is to be able to do that, and how much growth do you think you could drive in the future by still buying with yields above the yields of what you're selling?

Hey, good morning, Anthony. I'll try to take a go at that. If you look at what we did this quarter in terms of asset sales, you know, they were all relatively smaller transactions. Six of those asset sales that we did in the quarter were 1031 exchange buyers that resulted in about 35% of the total sale volume of the quarter. If you compare that to the second quarter, which was, you know, an equally large, relatively large disposition quarter, I think only three of those transactions in the second or four in the second quarter We're 1031 buyers. So I think as we look out to try to think about our disposition plan, we think smaller is better. Smaller granular assets are easier to finance right now because the other buyers, the non-1031 buyers, were generally to high net worth individuals that probably paid all cash for these properties. And there were some small funds that we were able to engage with and sell property to. So what I would describe to you today is we have a large number of properties on the market currently. You know, we're a very price sensitive seller. And I would describe all of these sales as generally non-investment grade sales. Like in the third quarter, none of these were IG related tenants. And so that would be like QSRs, car washes, you know, smaller properties. assets that are more bite-sized seems to have some attraction. So that's going to dictate the plan. It's really hard to project a target because I think you've heard some of the other commentary from our peers talk about declining 1031 depth out there, and I think that is the case because the upper leg of these transactions are being affected by other non-retail real estate sales. But we still believe that we'll be able to find a way to accretively recycle, and obviously that will in turn inform us what our acquisition appetite will be going into 2023. Okay.

And just to follow up, if I look at your acquisitions in the quarter, the 6.9% yield is is there any lag to the market adjusting cap rates higher here? And just trying to understand, like, if those were struck today, would there be any adjustment upwards? Just any comments on where, you know, cap rate adjustment is right now in your view?

Yeah, I mean, I think if you were to look at, there was definitely lag effect in the third quarter. I can tell you our fourth quarter is in already the low 7% cash cap range in terms of what we expect to close in the fourth quarter. And what we're seeing today, we're seeing things in the mid to high seven to low eight gap range for assets that a year ago were probably 150 basis points lower, just to give you some benchmark. So it's the same assets, just wider, 150 wider, especially in that industrial area. On the retail side, Tony, we're seeing probably 50 to 75 basis points widening compared to a year ago. So yeah, you'll start to see it impacted in our go-forward acquisition production. And so for us, dispositions, free cash flow are really pretty critical for how we're looking at next year's plan, obviously given where our equity is trading right now. We're not interested in necessarily issuing at these current levels.

Okay. Thank you. Okay. Thank you. Next question will be from RJ Milligan. Raymond James, please go ahead.

Hey, good morning. Just a question on leverage. End of the quarter at 5.2 times debt to EBITDA. Jackson, you mentioned that you're not interested in issuing equity at these levels. I'm just curious where you are comfortable taking leverage without tapping the equity markets.

I mean, we've talked about in the past, well, first of all, our ratings are really important to us. So whatever we do, we're not going to put that at risk. We've talked in the past, you know, 5.2 to mid-5s as kind of a range of leverage that we target. I think, you know, we're obviously set up with these additional terminal facilities to go past that if we found the right opportunities. To be honest with you, we'd only do that if we were confident that we could get the balance sheet back to a more normalized 5255 range. Does that make sense?

Yes. Yes, that makes sense.

And it seems like you guys are leaning a little bit more into industrial, and you mentioned that the cap rates have probably expanded there 100 basis points. I'm just curious. you know, what the expectation is in terms of absolute levels of cap rates in industrial over the next several quarters?

I mean, if you, I guess I would say, like, if you remember from my last, from the last quarter, we talked about, probably in too much, about high yield indexes and term loans and spreads widening. Well, that's continuing to persist for a lot of issuers. And, you know, if you look at our sale-leaseback percentage this quarter, it's about 60%. Close to 60% of our acquisition volume was new sale-leaseback oriented. In the first quarter, that was 45%. In the second quarter, it was 56%. I can tell you in the fourth quarter, it's north of 80%. What that means is we are finding opportunities where companies really need the capital with good use of proceeds And they're just evaluating a sale-leaseback versus, you know, accessing high yield bond or bank debt or term loan. And, you know, we're focused on mission critical assets in that segment. So I think you're going to see that sale-leaseback percentage continue to be very, very high as we move into the fourth quarter and beyond. Because that's where we're finding the most attractive opportunities. You know, if you think about my comments earlier about the dispositions, You know, we have a large number of properties that are existing leased assets on the market. We're not a for seller. If we don't get the right price, we're just not going to sell it. And so what we can do is kind of line up where we think we're getting fair value for the asset and transact. And those that we're not getting fair value will obviously not sell or pull those assets from the market. Well, that's what's happening in the market today. You have a large number of existing leased assets for sale, retail, industrial, office, and most of those are probably not going to sell. I mean, the volumes are way, way down. But there will be a small number of sale-leaseback transactions with companies that need to grow, need to go on with their business. And that's why we believe that we're one of a very few number of companies that can kind of solve that capital need right now.

A couple of our peers do it as well. Appreciate the color. Thank you. Sure. Thank you. Next question will be from Brad Heffern of RBC Capital Markets.

Please go ahead. Hey, everyone. Lost rent stayed relatively low this quarter at the 30 basis points. I guess, has that changed at all in October or November, and are there any signs of any tenants stressed?

Well, most of that lost rent was related to Regal. Mike, if you want to talk about that.

Yeah, I mean, definitely in the third quarter, that bump up in Los Angeles was really regal. They didn't pay September rent. They were required to. They did pay October and November, however. So I would expect that to relate to regal. That would obviously reverse itself.

Yeah, and all those leases are in effect, and obviously we're talking to regal along with many of our other – many other landlords that own regal properties right now.

Okay, got it. I wasn't specifically asking about Regal. I was asking more broadly on just tenant stress in general.

We always look at, we consistently evaluate our tenant base. Obviously, the fact that we're finding these opportunities for tenants that need capital, we're also very focused on our existing tenants in terms of where they sit and how they're performing. I would say the benefit of our portfolio, and we've talked about this in the past, is You know, it's very diverse from a tenancy, revenue, and industry, and location standpoint across our 2,100 properties. But more importantly, like, we have very large, sophisticated operators. You know, they've got different access to capital. They generally do a really good job. But obviously, we're very mindful, and we're paying attention.

Okay, got it. Thanks for that. And then there was a decent size drop in investment grade exposure quarter over quarter. It sounded like that was not due to disposition. So was that a downgrade or can you talk about what was driving that?

Yeah, Ken, you can take that.

Yeah. So what happened, the biggest driver of that change during the quarter was the downgrade of colds from investment grade. But none of the dispositions, as Jackson mentioned, were investment grade. That's not a You know, that's not a target for us on the disposition side. It was largely driven by the downgrade of coals. And, you know, a little bit of it also was driven by the acquisitions that we're doing today tend to not be investment grade. So you're adding more non-investment grade, and you have the downgrade of coals.

Okay. Thank you. Sure. Thank you. Thank you.

Next question will be from Josh General, Bank of America. Please go ahead.

Yeah. Hey, guys. I guess I'm curious, like, on the dispositions, is it more about kind of optimizing portfolio, like how you want it to look, or are the sales more about kind of optimizing capital raising? I'm curious how you kind of balance those objectives.

I would say it's first – It's both, really. But the optimizing of capital is probably in the current, for us currently, given our current public, we traded cost of capital, it's paramount. Because, you know, we have a very diverse, liquid, granular portfolio. So we have lots of opportunities to try to harvest those opportunities and reinvest in things where we have a lot of conviction around right now. But also, you know, it gives us an opportunity to that continue to shape this portfolio. You know, we constantly are evaluating the different industries that we're in and trying to find kind of that sweet spot of balance, of diversification. And I think for us, you know, adding more industrial, we think is a wise thing to do. And we've consistently been doing that. And we'll try to do that going into 2023, obviously in the fourth quarter as well. But the other thing it does, Josh, is, It's very informative to have a lot of properties on the market for sale. We get to see the depth of the bidding universe, how different groups are coming in and out of the market. And that's just extremely valuable information for where I sit. When we think about, is this the right time to be investing for us relative to maybe it might get better later. So that's just really, as opposed to hearing it from brokers or Other consultants, anecdotally, like we know real time. I can tell you, like if you looked at the buyer list and bidding list between the second quarter and third quarter, it's very, very different. The depth, the number, the type of buyer is very, very different. And we're seeing that in our current disposition pipeline that we have right now. It's very much happening in the moment.

Okay.

So we think it helps us. It informs us to be a better buyer.

Okay. Then I guess if nothing really changes on your cost of capital, should we kind of assume that your net acquisitions going forward are going to be kind of smaller than in the past just because you're going to be doing more sales? Is that a good way to kind of think about it?

Yeah, look, I mean, I'm not excited about our cost of capital in terms of where our equity yield or AFFO yields right now. With that being said, we generate a decent amount of free cash flow. The portfolio is of a size right now where it's large. It's not super large, not super small, but it's large and diverse. And I think what you can expect from us is we're going to be extremely opportunistic on how we think we need to fund ourselves. I think if you look back since I think I've been at this company, this team, we've always – been pretty thoughtful about how we raise capital to fund our business. And sometimes, you know, it's through ATMs. Sometimes it's through larger offerings. Sometimes it's through dispositions. And I think we'll continue to do that. And, you know, I hate to sort of forecast what happens if this happens or that happens. But I said to you, we're not going to raise capital that's dilutive, number one. And we're going to continue to push really hard on the dispositions. It's a core priority in the company. And, you know, if those things don't materialize, obviously, you know, you have leverage as a kind of a toggle. You want to go that route. But I said also ratings are really important. So we're going to be really thoughtful as we come up with our 2023 plan. And look, we're not going to be heroes or anything like that either. So we'll just be very measured and try to find the best opportunity that matches up with what we believe are great opportunities to enhance this portfolio that we own.

Thanks, Jackson. Thanks. Thanks, Josh. Thank you. Next question will be from Handel St. Just of Mizzou. Please go ahead. Hey, good morning.

Good morning, Jackson. I wanted to go back to investment spreads for a second, but more on a look-forward basis. It looks like your cost of capital today is somewhere in the high sixes. I'm curious what type of spread you think you can generate as you deploy incremental capital today? And then some thoughts, or maybe can you discuss the pipeline, what the cap rates in there look like? Thanks.

Well, I'll do pipeline first. You know, we're being extremely picky on things that we're looking at right now because the number of opportunities is continuing to increase. And I think I've characterized it, the buyer base for the things that we're looking at It's relatively small. It's a handful of our public peers, especially for some of these larger opportunities, larger being north of $20 million. And the private buyers that need mortgage debt, I mean, they're not really able to do it, I don't think, right now. And so I guess the way we think about it is, look, we have free cash flow. We have disposition proceeds. That all goes into the cost of capital mix. We know what our AFFO multiple and yield is. You know, we were able to get stocks sold last quarter, you know, in the low 40s. At these current levels, cap rates would have to be extremely, extremely high for us to consider that, I think. And right now, I would say cap rates are still widening. I'm just not sure how wide they'll ultimately go, but At some point, I think you kind of run into a ceiling, but high sevens to low eights is kind of a reasonable area where we think we might be able to get things done next year. Mid sevens to low eight cap rates for assets, once again, that were probably 150 basis points tighter a year ago. So it's not like we feel like we're buying low quality opportunities. These are very, very good opportunities. There's just not as much capital out there.

Got it, got it. That's helpful. Appreciate that. And then a question, I guess, stepping back. You've typically given forward your guidance during third quarter earnings. Sounds like the decision this year is probably a function of the macro uncertainty and needing more clarity on your sources and cost of capital. But I think many of us are trying to get a sense if it's reasonable to think of third quarter, the $250 million-ish, as a good run rate, given the elevated cost of capital and debt pricing and the shift in the market. And so I'm curious if that's fair. And then what type of growth do you think you can generate without issuing incremental equity capital and still operate within your leverage targets? Thanks.

Yeah, I mean, we didn't put the guidance out, particularly because of some of the challenges in the macro environment right now. You know, I wouldn't want to even try to Yes, right now. You know, like I said, we have a large number of properties on the market. I'm not going to tell you exactly how large, but when I say it's large, it's large. If we were able to execute at those levels, that would help us kind of drive a certain type of acquisition activity next year. If we're not able to achieve it, you know, it's probably going to go down for next year, the volumes. But it's hard to answer that right now. That's why we didn't want to put it out there until we get a little more information through the close of this year and early. I think we'll be better informed to give the market an idea about next year's earnings and growth and acquisition volume.

I appreciate that. I understand. And then just one last one, if I could. I'm curious if you could update your view on potential M&A, how that maybe has been evolved or maybe been impacted by the change in the cost of capital, the contraction, the spreads. It seems that the spread investing equation here has changed pretty meaningfully and likely weighs on the growth and likely limits the upside for the stock. So just curious on the latest thinking for M&A here. Thanks.

Yeah, I mean, I think one of the companies that was taken private, obviously, I think it was a unique situation. I'm talking about store, right? And I think that for me, the positive sign for that is you had a global sovereign wealth fund that has sort of embraced this net lease asset class. That's wonderful. I think that's wonderful for us and for all of our peers. That company had just very unique ABS facilities like we've had in the past that I think enabled them to kind of be able to generate the kind of cash on cash yields that that investor required. I mean, for us, we're not necessarily set up that way. All of our debt's unsecured. You can see how our bonds trade. But more importantly, I think it's hard to predict M&A in the future. I think, look, the environment's not great right now. The macro environment is a little bit distasteful. And so usually that doesn't result in a lot of M&A, unless it's maybe stock for stock, but also very difficult right now. So I would say like for what we're focused on, the things that we can control, we want to make this portfolio and company better, constantly improve it. We believe that this shift into a higher percentage of industrial assets, new sale leasebacks, long-term leases, higher annual rent bumps, you know, that the rent bumps are exceeding 2% now. We think that's going to position this company better in the future. You know, whether we get the equity multiple or maybe we can attract, you know, sovereign wealth funds to do things with us, sure, that would be great. But we just want to make the company better. And that's what we're really trying to do right now. And we think what we're doing is doing that in our control. But to answer your question, I don't think there's going to be widespread M&A right now.

The environment is just too uncertain for a lot of companies right now.

Thank you.

Sure. Thank you.

Next, our question will be from Michael Goldsmith of UBS. Please go ahead.

Good morning. Thanks a lot for taking my question. Can you remind us just how much prior right you collected this year, how much you have remaining for the fourth quarter, and what you expect leading into next year?

You're talking about deferred rent, is that? Yeah. Are we talking about deferred rent, Michael? Yes, correct.

I know we have about $9 million left to collect, and I believe we'll collect roughly 60% of that by the end of next year. I have to look back, and I think we've collected about that this year. And, you know, all of our deferred rent has been repaid, you know, per the obligations of the tenants on time. So, you know, it's been moving along. I think that when we struck all our referral agreements, that balance was well into the 20s initially coming out of COVID. So it's come down materially. We've even had several tenants, you know, prepay early. So it continues to drop.

So, yeah. Thanks.

And then just on, you know, the portfolio shifting from, or at least the acquisition or investment is shifting to industrial from retail, but there's a, big pickup in the home furnishing space. And that's one that, you know, may be facing a little bit more challenge in this current environment, given that there was a lot of, you know, there was a lot of home buy, furniture purchasing and home furnishing purchases through the pandemic. So just trying to get a better understanding of what you're seeing in this category and why the focus on it in the third quarter.

Yeah, Mike, so the two-home furnishings, we bought a Lazy Boy and a small pool, yeah. It was a Lazy Boy and an Ashley Furniture location. I mean, like I said, those were existing leases. They were not sale leasebacks. They made sense at the time when we were looking at them on a relative basis. But if you think about what we're doing now, it's just really shifting more to that sale leaseback opportunity that I talked about. you'll see that shift in the fourth quarter, and it's going to be predominantly industrial in that fourth quarter. So I would say some of that, some of the assets that were acquired were probably earlier in the year committed that were rolling in, but my comments on how we're moving forward is going to be primarily industrial, long-term lease, set lease back, new set lease back.

Got it. Thank you very much.

And, Michael, I'm going to go back to your question. I will just go back to your question on crude rent real quick, just to make sure I'm clear. You know, all the deferred rent we've been collecting, that was all recognizing earnings last year. So none of that's affecting our earnings, just to be clear. That's all that was recognized last year in the second quarter. And so the rent that we have collected and continue to collect does not actually impact our earnings.

Yeah, so you won't be facing, it's not like you have to lap that next year.

Correct. That's right. Yeah, none of that rent we've collected this year was recognized in earnings for this year. It was all recognized last year, all in one quarter.

Are there any, you know, as we look ahead, I know you're not providing guidance, but are there any one-time items from this year that you will have to lap or any potential benefits?

Yeah, I mean, I talked about, like, the other income. That line-on got a little chunky this quarter. So, you know, that tends to be more non-recurring.

Thanks so much. Good luck in the fourth quarter. Okay. Thanks, Michael. Thank you. Next question comes from Kenbin John of Truist.

Please go ahead.

Thanks. Good morning. Good morning, Kevin. So when you talk to your tenants, what's your best sense of, for them, the cost of a lease versus alternative funding sources, and is that spread Has it gotten wider, I guess more favorable or unfavorable as it pertains to doing a lease?

Yeah, and for a lot of some of the companies that we've been targeting, especially the non-investment grade tenants, a lot of these companies are sitting on SOFR plus 400, 450 kinds of credit facilities. And like their secondary bonds might be trading at 11%, double digit. And if you kind of focus, you know, I talked about this last quarter, but the high-yield issuance, new issuance volumes are way, way down. Part of that is that the new issue premium is so high right now for a new add-on bond just because the secondary bond levels are trading so wide. And I think that's just a function of there's a whole – we're going to have a longer discussion on why spreads are so wide right now. Obviously, a lot of global cross-currents, the U.K. There's just a lot of things right now that are creating extremely wide spreads. You know, for us, as a sale-leaseback alternative, you know, if we can lock in at 8.25%, numerically it's lower, right, than what they can issue at bank debt right now, even new bonds. But, you know, where the tenants kind of push back on us, it makes sense. You know, if they issue a, you know, a bond or term loan at those higher rates, they can always prepay that debt. There's either prepayment or yield maintenance or defeasance. They can actually prepay it. The minute they enter into a sale-leaseback on a mission and critical asset with us, it's a 20-year obligation. You can't get out of it. And it has certain inflexibility sometimes for them. So when they look at doing a sale-leaseback versus just issuing corporate debt, it just has to be probably a little bit lower, just given some of this elevated spreads and where absolute corporate rates are right now. And so that's why I've said that we're not going to do 10% sale leasebacks right now. I don't see right now in the current environment. But we are seeing that 150 basis point widening. And I think it's just a function of supply and demand of capital that's willing to do it, i.e. us and some of our peers. And these companies, they need to move on. Some of them are growing. Some of them are expanding. Some of them are doing mergers. And they need the financing. So... So we're kind of trying to thread that sweet spot, really good credits that we believe good industries, really good real estate, great leases at what we believe are wide pricing from a historical standpoint. And we think that in the future, spreads will normalize from where they are today, eventually. So that's kind of the lens that we're looking at. Okay.

Okay. And when you look at your 2023 lease expirations, you have about 3.2% rolling. Any early thoughts on how lease negotiations are progressing and broadly what we should expect in terms of retention rates or spreads?

Yeah, hey, this is Ken.

You know, the lease expiration is going to be strength with you is just the basic blocking and tackling that we're doing every day. We're not only, you know, addressing 23, we're addressing 24, 25, and even in some cases, 26. But we're very happy with the way, the progress that we're making. You can see in that, you know, in the lease expiration schedule, it's interesting if you look at the leases that are expiring in 33 and beyond, And that thereafter line item, we've managed to move that up for several quarters in a row. So, you know, we're very happy with the progress we're making.

So, I guess, let me ask you a different way. Any reason to expect the retention rates to be any different from what we've seen from you guys for the past, like, year or so?

We don't see anything materially different. Okay. Thank you. Thank you. Next question will be from Wes Galladay of Baird. Please go ahead.

Hey, good morning, everyone. I want to take a look at the sell-leaseback activity that you're doing. Are you seeing better value at a particular price point, and how has competition changed throughout the year?

I think, Wes, the way I would answer it, there's a lot of sell-leaseback opportunities that won't get done. They don't make sense. They don't make sense for us. I don't think they make sense for anyone. That's one sort of bucket. What I would tell you is that larger dollar-sized deals are just less people that can actually do those right now, and that's an area that we're looking at very carefully right now. I would just say there's a lot of companies that need capital, and they're obviously kind of like, oh, I'll do a sale-lease buy, and I just don't think a lot of them are going to get done. So I don't think – it's hard for me to overgeneralize and answer your question. All I can tell you from our lens, we're seeing lots of interesting stuff at very wide pricing relative to what we saw a year ago. We don't have to be mindful that we don't have infinite sources of capital right now that are accretive. So we're trying to be very measured and methodical as we move forward from here.

Got it. And then when you look at your cost of capital, there's all kinds of ways to measure cost of equity. But it looks like it's adjusted for the 150 basis points change you've seen in cap rates. But is it the debt side that you're more concerned about on the cost of capital at the moment that will keep you from dialing up more volume at this point? Mike, you could... Yeah, no, actually, we're much more comfortable on the debt side. We did the $800 million term loan that we fixed. We have today our $1.2 million Billion-dollar line is completely undrawn. We had $100 million of cash on the balance sheet, and then we have this new $500 million term loan coming in. And if you think about just our liquidity from a debt capacity standpoint with this new term loan, that will carry us all the way through next year, probably into 2024, without having to access any of the debt markets. So from a debt standpoint, I feel pretty set. I think it's more of the equity side that we're focused on. Okay, got that. And then revenue producing CapEx, there's a lot of stuff that goes into that. That picked up this year. You mentioned about funding a lot of the acquisitions with dispositions and free cash flow. So just curious how you see the revenue producing CapEx trending next year.

Yeah, I think that's something that I think will continue to be a part of our investment structure. It's generally related to existing tenants. And we think that it's important for existing tenants that we're prioritizing to kind of be constructive with them. Obviously, we have to adjust for the current pricing environment with them if we decide to do that. But I would say, like, we'll have a mix of revenue-producing capital as well as, you know, straight-up acquisitions that are new sale leasebacks that are industrial next year. I just can't give you the percentage of the volume right now.

Got it. Okay, thanks.

Okay.

Thank you. Next question will be from Greg McGinnis, Scotiabank. Please go ahead.

Hey, good morning. Jackson, as we head into a, you know, maybe more challenging economic environment, how are you evaluating these non-investment grade industrial sell-leaseback tenants to determine those with, you know, good uses for the capital that you're providing them versus those maybe looking for a cash out?

Yeah, I would say we're not focusing at all on cash outs. You know, it's the normal blocking tackle you would want us to be focused on. You know, it starts with, you know, what type of industry they're in. How are they positioned? What does their balance sheet look like? How much floating rate debt exposure do they have? How much concentration do they have from their revenue sources? How reliant are they on FX changes? How are they, you know, just a variety of different things that you go through on credit 101. But I think for us, the key thing is how mission critical is this real estate that we're looking at? What is the rent relative to what we believe market? What would be the potential reuse for this facility? How critical is this industry? If, God forbid, there had to be a restructuring, what would that look like? Is it a 7 or 11? How valuable would these properties be? All of that kind of goes into our calculus before we kind of make a decision to move forward. But what I would tell you, what we're not doing is high rent, high levered, over-rented set leasebacks. That's, that's not what we're talking about here. Um, and I think, you know, if you look back, you know, I kind of specifically referenced the sale of that Hagen property. Um, you know, if you kind of roll the tape, if you remember that, you know, that situation, you know, it was a $224 million acquisition, um, You know, back in the day, obviously the company filed for bankruptcy, but, you know, we were able to obviously restructure leases with new operators, and obviously that was done with kind of the prior regime here. But what we've been committed to do is continue to sell those. So if you sort of look at the tape, we've sold all but one of those properties at this point and generated sale proceeds of $249 million. as well as generated another $75 million in total rents and settlement fees since the acquisition of that portfolio. So it's been almost $100 million net gain over purchase price and 50% on the investment. And it just goes back to why was that? Good real estate, generally locations that operators wanted to go into, and very granular and liquid, like those two smart and finals that we sold. And so we've continued to take on that thesis on everything that we bought. Everything that we bought since I've been here. So it's important. And it's not just the lease. There's a lot of factors that go into these decisions that we make when we're sort of deploying capital.

Yeah, thank you. Appreciate the color there. Mike, just a quick one. Are there any plans to swap the new term loan? And if you did, what might that all-in rate look like?

Yeah, that's something we're going to evaluate. So we have time before we would draw that down. We have until July. I mean, if I look at today, I think that we'd be looking at swapping into the mid fours. I think that's probably a little steep and the short in the curve is a little elevated and it's two and a half year term loans. So you're looking at the shorter end of the curve. I think if you look at how we did the last swap, we timed that pretty well. We did it actually well before we even closed that term loan because rates dipped. And so we took advantage of that. And I think you'll look at the same playbook here. We see the rates dive where we think there's an attractive price. We'll swap and we're going to have six months to do that. And we also take the view that there's going to be a lot of doubt that's going to come out between now and July with the Fed. And that could affect the trajectory of rates and the curve. We could take the view that we want to stay floating. We have a conviction that rates are actually going to come down over the life of that term loan. When we use it, if we have that conviction, we'll leave it floating. So I'd say it's too early to tell. But we obviously prefer to be fixed where we can. We're going to evaluate that and try to be optimistic with how we approach that.

Great. Great. Thank you. Thank you.

Next, our question will be from John Masakoka of Landberg-Fullman. Please go ahead.

Good morning. Good morning. Good morning. So, can we just dig into the kind of industrial acquisition pipeline a little deeper? What's the bifurcation in there between maybe manufacturing and warehouse distribution assets? And has the cap rate and kind of cap rate expansion you've seen over the last six months differed between those two kind of specific tenant industries?

I'll let Ken. Hey, John. So what I would say is there's not a bright line, but we tend to look at more of the light manufacturing opportunities, but I would submit that when you're looking at a light manufacturing facility or, you know, a pool of facilities in a transaction, they typically have a distribution component. It's very common to have that component within the facility. But, you know, as far as pure light manufacturing versus pure distribution, I would suggest it's going to be more on the light manufacturing side. And, you know, there might be a little more yield expectation for those types of assets, but it's not some huge divide.

Okay. And then maybe sticking with Ken, if you think about your seeded assets, is there any kind of read-through, I guess, in terms of tenant credit health from what's going on with Regal, or is that kind of a very isolated situation in your mind?

You know, we clearly view theaters as kind of in their own bucket. They've got their own industry. Here's what I will tell you. We tend to have a lot of regional theater operators within our theater bucket. They're doing phenomenal. They're solid. They came out of COVID extremely well capitalized. I would submit that in some cases better capitalized, you know, through the SVOG program than they've ever been. You know, Regal's got its own path. You know, we're going to deal with that. Interestingly, not only our regional theater operators, but others that we don't deal with today, we do get inbounds on the Regal assets, you know, about interest in them. So, you know, theaters are definitely different, but we're comfortable, especially with our regional operators.

All right.

That's it for me. Thank you very much. Thanks, John. Thanks, John.

Thank you. Next question will be from Spencer Alloway of Green Street Advisors. Please go ahead.

Thank you. Maybe just sticking on the tenant health topic for a second, just given the high inflationary environment, can you guys comment broadly on rent coverage in the portfolio and how that may have changed in the last six months?

It's actually a very stable sensor. I guess I'll just tell you the way I think about it. You know, 20% of our tenant base is investment grade. That has a certain kind of, obviously, risk profile as we go into this more uncertain macro environment. You know, 53% are public. Some are investment grades. Some are non-investment grade. Some are just, you know, have no rating. And then we've got a 29% PE bucket. You know, generally you should expect more non-investment grade debt facilities, you know, in their capital structure on their portfolio companies. And then we've got sort of another 19% that, you know, individual operators, which by the way, some of those are really large, especially on the restaurant side, pretty good credits. So, you know, we don't have, I sometimes see people look at us as, oh, you're a high yield portfolio. It's not really true. I mean, statistically, it's not true. And it's also very diverse. So I think what we're trying to really ascertain as we go through working with our credit team, especially on a non-investment grade tenant base, where are those sources of revenue coming from? Are there things on the horizon that could change their prospects? So obviously during COVID, a lot of tenants were impacted by transportation costs. just because of logistical issues that were happening. Now, some of that's burning off, right? You read about what's happening with ports and the cost of moving goods, containers, and freight coming down. But there's other issues. There's companies that have global FX exposure are being impacted. And so I think for us, we try to really understand what that concentration of revenue looks like and how it could be impacted. And obviously, as I said earlier, on balance sheet where these companies are with floating rate debt. Where are they with maturities? How is your lender base looking at them? Because I do think it's going to be different this time. COVID put a lot of pressure on lenders, but there was a lot of forbearance. I think this time I'm not sure. It depends on how long and deep this economic environment that we're going into persists. But I can tell you that we spend a tremendous amount of time looking at it. you know, with the team.

Okay, that's really helpful, Collar. And then just one more, you know, with new acquisitions being heavily industrial focused, can you just give us a sense maybe directionally of how coverage for that particular property type compares to the portfolio average?

So, you know, what's interesting about industrial, you know, there's a fair amount of them where the unit level coverage is not applicable, obviously, but we're going to look at corporate coverage. And we certainly, that's an ingredient when we do the underwriting. But I would say as you, as we evolve into heavier industrial, there's going to be a lot of occasions where unit level's not a factor. But we, you know, we look at other things, you know, in industrial, the rent on a facility tends to be a very minor line item in the expenses. There are things that we're looking at rather than unit-level coverage that make more sense for the asset. But we certainly aren't going to be looking at opportunities that are, quote, dilutive to the coverage, at least at the corporate level.

Okay. Yes. Sorry. I sort of tally-outed that with yes. I was talking about corporate. Okay. Well, thank you, guys. Appreciate the color.

All right. Thanks, Spencer. Thank you.

Next question will be from Linda Sy of Jefferies. Please go ahead.

Hi. Good morning. When you do sale leasebacks, how much discretion do you have in terms of deciding which assets go into the deal, and what do those conversations look like?

I can tell you a year ago they were really hard. There was a lot of people – it was more of a seller's market. So it was a kind of take it or leave it or take it this way or that way. Terms were really tough. From a buyer standpoint, like tenant had a lot of leverage. I would describe it to you as completely flipped. The money has a better ability to determine what is what, like what goes in, what goes out, and what the terms are and what the rates are. It's really flipped just because my earlier comment, there are a lot of sale leasebacks that are in the market or being, you know, trying to be sought after that will not get funded. And so I think it's a great time right now, not just for pricing, but for sort of terms that we're able to get, assignment language. You know, back in the day, you used to have covenants on sale-leasebacks. I'm not sure we're there yet, but it used to be like financial covenants on some of these things. If you looked a long time ago, back before all these companies were as public and as active. But right now, the sale-leaseback is really solving an important part of a corporate capital structure right now for companies that want to grow. Obviously, companies that want to take out equity are trying to do that as well, but I would suspect hopefully most people are pursuing those kinds of opportunities.

Thanks. And then in terms of the types of assets you're disposing to recycle capital, out of your asset mix you have retail, industrial, office. Which assets are you seeing reach fair value the fastest to the point where you're willing to sell?

Yeah, I mean, I think if you look in the second quarter, Linda, like we got a lot of traction on, for instance, like a B of A building. We've got really great pricing. We sold some of our, you know, industrial assets because, once again, it was very, very attractive pricing. And also we wanted to, believe it or not, have kind of proof of concept. You know, we've been buying a lot of industrial property since this team got here. And I think we've been successful at it. And we're trying to demonstrate, you know, an ability to show people we can buy things that make sense and see compression in yield on the sale. If you looked at this quarter, it was all small assets, Taco Bells, little restaurants, a couple grocery stores. I think as you look at the pipeline going forward, it's probably looking more like that, smaller bite size opportunities, not really larger assets. But that could really change, you know, as we go into the new calendar year. You know, you sort of never know how fund flows work, you know, if spreads tighten and there's obviously a lot of appetite. It's just that where people are trying to discover pricing. So we can pivot our disposition plan to do larger retail assets, you know, larger department store opportunities or retail opportunities. You know, if we were not successful there, we'd consider selling industrial as well. But right now, I would stand to your question. It's a lot of small, granular restaurants, car washes, things that we believe, you know, $3 million to $5 million size deals that we think can clear right now.

Got it. Thanks for the call. Sure. Thank you. Next question will be from Chris Lucas, Capital One. Please go ahead.

Hey, good morning, guys. Actually, Jackson, just following up on that granular portfolio, how much of your aggregate portfolio do you think is comprised of sort of those more liquid, better valued, smaller assets?

I would say in terms of number of properties, we have 2,100 properties. I would say, just going to guess, definitely the majority fall in that bucket of small and granular. You know, drugstores, you know, auto repair shops, caliber collisions, that sort of thing. You know, we do have larger assets as well, right? Some of these industrial properties we're buying are bigger. They're probably not as liquid today, just given they need mortgage financing and probably don't appeal to that 1031 universe, but But I would say the large majority of asset we have fit in that sort of $3 million to $6 million, $7 million size asset. I mean, it's 2,100 properties, right? So, yeah, so there's no shortage. I think what we, Chris, focus on is, you know, when we sell a property, you know, what's the tax impact to us? What's the lease duration? You know, there's a certain type of asset that has a certain minimum cost. Walt on it that makes sense for the buyer base out there to get the pricing that we're focused on. So like this quarter, you might see more drugstore sales, for instance.

Okay, great. Thank you for that.

And then, Mike, I just wanted to – there's sort of a detail I wanted to iron out. So in the capital deployment activity spreadsheet that you have in the deck, it's showing – average annual escalators in the one and a half to one nine, sort of through the trailing eight quarters. And then if I go forward, there's a forward sort of average rent increase number that you guys postulate as 2%. I guess, are the numbers comparable? Am I missing something between the two slides?

Yeah, so the forward number is basically the point in time number. So now over the next 12 months, kind of point to point. how much do we expect our rent to escalate organically? And I've talked about this before, but one thing that is elevating that number a little bit is those movie theaters that we re-let, they had some pretty big escalations as they stepped up from the base rents when they were put in to their finalized base rent. There was some runway built in as those things ramped up with the new operators. That's going to be done by the end of this year. And I'd say pro forma, if you pro forma those out of that number, you're probably closer to our historical average of about 1.7%. So that is adding a little bit of extra growth this year. So as we flip into next year, I expect that number to come down a little bit, probably around that 1.7% range. That being said, as we think farther out, if we continue to buy more industrial and sell more of the granular assets, which tend to have lower escalators than the industrial that we're putting in, which tend to be more of the 2% to 3% escalators, then you'll see that number kind of start to creep up over the longer term. But I think in the near term, you will see that kind of come down a little bit as those movie theaters kind of stabilize.

Okay. And then just one more for you, Mike. Just on Regal, can you just remind us sort of how you accounted for their deferred rent? And is there anything that you guys will need to write off based on their filing or were you on a cash basis? Or can you just kind of give us a quick history there?

Yeah, they were not on a cash basis. They are today, obviously. We only had $135,000 of cash rent that was deferred and recognized in revenue, which we reserved for in the third quarter. So that is now fully reserved. Obviously, the September rent they didn't pay is also fully reserved because, again, they are on a cash basis. So that's all been reserved for in the third quarter. So there's nothing else, no other impact with Regal other than wherever we get to with their leases if that changes.

Okay, great. Thank you. That's all I had this morning. Appreciate the time.

All right. Thanks, Chris.

Again, if you have a question, please press star then one. Next question will be from Ronald Camden, Morgan Stanley. Please go ahead.

Hey, just a couple quick ones for me. Just going back to the acquisitions, obviously the cap rates moving up this quarter. As you're sort of thinking about sort of next year, right, there's a tradeoff between volumes and cap rates. So is the thinking that, you know, should we be expecting sort of more cap rate, higher cap rate deals given sort of the cost of capital, or would you be willing to sort of, you know, step back on the acquisition volumes? Just trying to, how are you guys thinking about that?

Hey, thanks, Juan. I'm thinking about both of those alternatives, to be honest with you. You know, we haven't committed just to sell the self. and buy to buy. I mean, I think what we're doing is taking very measured steps. As I said, we have a lot of properties on the market currently. That's going to inform us, you know, not just on proceeds, but cap rate. You know, we have another tranche that we're prepared to move forward on. And we don't have to sell these once again, right? It's only if we get what we believe is kind of the right price for what's being offered. Um, and I think we're equally being measured on the investments that we're committing to or evaluating. So we're really, we're trying to, we are not getting ahead of ourselves one way or the other. We're not going to oversell without a pipeline and we're not going to build a big pipeline and try to sell down. We're moving very much a lockstep, which is why I keep referencing large number of properties on the market. And if the market improves where we think we can sell kind of larger either pools or assets, you know, we'll obviously pursue that. That's why we don't want to probably, we don't want to give guidance because it's really hard to tell. We're looking at all sorts of different alternative scenarios here. And so we'll be in a better position to do that in the early part of next year after getting a lot of feedback from the assets that we have in the market. And also what we're seeing, as I said, you know, on the cap rate side for acquisitions. But we think we're, We're being as smart as we can about giving us maximum optionality because we could easily just sit and do nothing. Obviously, we're not going to sit and do nothing, but we just sit and just collect rent. But what we want to do right now is take an advantage to try to improve this portfolio as we move into 2023, given all the things I described to you on the investment opportunity with sale respects with industrial companies. So that's kind of the plan right now.

Great. And then my last one was just taking a step back, just trying to get a sense where your head's at, just strategically with sort of the cost of capital environment today, right? Debt markets are very high and the equity is still down. You guys got a forward done this year, which looked really smart and so forth. So you're sort of thinking out of the next two to three years, What other sort of tools, options can you sort of draw on in these periods when cost of capital is maybe not there? Is it the JV capital? Is it trying to time more? Just trying to get your sense strategically how you sort of operate when the cost of capital is not there. Thanks.

I think for me it starts with execution, operations, doing what we're supposed to do, monitor credit. stay close to our tenants, collect rent. You know, our performance, if you look across lost rent, property cost leakage, very low default rates, getting through COVID, in my opinion, it's been really, really strong. And we're going to have another opportunity, I believe, during this very uncertain time to be able to prove out the same level of execution. So that's really first priority for this organization that we're focused on. You know, if you kind of are able to do that, I believe, well, like the markets kind of come, they ebb and flow. You know, high yield indexes are really out of favor right now. In my experience, that's not forever and not permanent. And I believe you'll start to see a rotation at some point where high yield indexes really start to compress, maybe faster than investment grade indexes. And my suspicion is that's when we're going to probably outperform as the macro environment starts to loosen up. And we'll be in a great position to move forward based on that. I don't think we're going to try to do things that would be distractive right now from what I just described. Just primary blocking and tackling execution day to day for our 300 plus tenants across this 2100 portfolio company because we spent All this effort the last three years building this fortress balance sheet, I want to take advantage of that at the right time, and I think we'll get that opportunity sometime in the next couple of years.

Great. Thanks so much. Thanks, Juan.

Thank you. That concludes our question and answer session. I'll turn the conference back over to Mr. Jackson Say for closing remarks.

Okay. Thank you, Operator. I appreciate all of your interest in participating in this call this morning, and we really look forward to seeing many of you out at NARIT in San Francisco next week. Thank you.

Thank you. Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.