2024-01-08 03:38:58 ET
Summary
- EPRT focuses on mid-size regional or national companies in sectors that are less likely to be disrupted by digitalization or e-commerce.
- The company's stock has fared rather well compared with the competition in the last difficult year for REITs.
- Prudent debt management and positive investments for growth seem to point to a great future.
This article is meant as an update to my previous buy-rated publication in June 2023 on Essential Properties Realty Trust (EPRT). I love EPRT for many reasons that I will explain in this article, and I was pleasantly surprised as well by some of their growth strategies employed during the latest quarter. The stock has overall held fairly well as of recent (it is up about 10% in the past year), although it is still down about 20% from the all-time highs reached in September 2021.
The company is fairly insulated from interest rate movements (as much as a REIT can be) thanks to a prudent debt profile, which is a huge plus in my book when the economy is experiencing an interest rate hiking cycle. EPRT is enjoying faster growth compared to peers and management is still guiding for 5% growth next year, while shares are trading at a fair valuation in my opinion. The stock is looking very interesting for boosting a portfolio's exposure to the real estate sector.
Smaller tenants for faster growth
EPRT is a REIT focused on the experience and service sector with a healthy, diversified tenant base. The company is able to closely monitor 98.7% of their tenants' financial stability through consistent reporting in relation to their debt levels and earnings. On average the tenants' unit-level rent coverage stands at a very healthy 4x, meaning that their rent obligation is roughly 25% of their actual earnings. Meanwhile, the leases signed by EPRT are very long in nature and at the moment the Weighted Average Lease Term is 13.9 years and the occupancy rate is nearly perfect at 99.8%.
The general strategy of the company has always been to target mid-size regional or national companies, operating in businesses that should not get disrupted by mega trends such as digitalization or e-commerce: think of car washes, early childhood education, medical or dental offices and the likes. About 92.8% of EPRT's portfolio is devoted to businesses operating in the service and experience sectors, while the remaining portfolio has exposure to retail, industrial and building materials.
EPRT Investor Presentation November 2023
Targeting this market segment is a double-edged sword. From one side the company is exposed to sectors that should fare relatively well in difficult economic scenarios as the tenants offer essential or low-cost services, which do not require customer financing to purchase and might be resilient in difficult times; on the other side though, by targeting small or middle-size companies EPRT exposes itself to potentially more harm if the economy heads towards a rather nasty recession given that smaller companies are those suffering the most in those scenarios. As everything in life it is a matter of balance between pros and cons: I'd take these odds personally.
Prudently managed debt is a big plus
EPRT has less debt compared to competitors (EPRT Investor Presentation November 2023)
One of the primary reasons for why the stock has held up so remarkably well during the REIT meltdown of 2023 is how prudently debt has been managed at the company. The EPRT had only one $200 million maturity scheduled for April 2024 which has been recently refinanced by issuing new debt due in 2029 . Naturally the interest expense on the new debt is higher compared to the previous one (6.3% vs 5.3%), however that is the reality of a new normal where the Federal Funds Rate is not nearly zero. It is crucial however that only 200$ million had to be refinanced while the remaining debt consists of rather long-term maturities.
While other competitors had to deal with huge near term debt maturities that have seriously impacted their cash-flow and had to resort to dividend cuts (I am looking at you WPC ), EPRT has well-laddered obligations while having no maturity before 2027.
From that year the company will have debt maturing for $430 million in 2027, $400 million in 2028 and $450 million in 2029. Everybody is expecting the Federal Reserve to start cutting rates already during 2024 , and although there is a debate if the pivot will happen in the first or second half of the year, this does not impact EPRT at all: whenever that happens, they will enjoy better conditions compared to all the other REITs that had to refinance large portions of their debt at peak rates.
EPRT Investor Presentation November 2023
I personally believe that inflation seems mostly tamed. Economists are debating whether the last stretch toward the target of 2% inflation will actually be harder than what has been achieved until now, nevertheless I would be very surprised if by 2027 inflation will still be an issue that prevents the Fed funds rate from stabilizing around a more normal 3.5% to 4% range. This will effectively allow EPRT to eventually refinance their debt obligations at the same or even better interest rate compared to their current terms.
EPRT is still investing in its growth
EPRT projects better growth compared with the competition (EPRT Investor Presentation November 2023)
Many REITs have experienced a sort of freeze of their activity as the speedy interest rate hiking campaign by the Federal Reserve has resulted in much higher cost of capital while real estate values did not re-price downward accordingly. It is interesting to see that EPRT has actually continued to acquire new properties by directly leveraging their good relationship with their tenants. During the latest quarter , the company acquired 65 new properties, all sale-leaseback transactions and 86% of those came from existing tenants. For context, sale-leaseback transactions occur when a company owns the real estate they operate in, but decides to sell it (to EPRT in this case) and to immediately rent it back: the benefits of leasebacks is that the seller enjoys an influx in cash while experiencing no disruption in their operation.
On the flip-side, from EPRT's point of view these transactions appear very attractive as the tenants are already in place, committed to continue their operations for a long time. On these new acquisitions EPRT enjoys a weighted average lease term of 17.6 years and average annual rent escalators of 2%, which is on the higher side compared with their total portfolio (1.6% on average).
I love to see the company so active when so many other REITs have had limited opportunity to put capital at work. Management seemed actually quite upbeat on the subject when replying to an analyst question during the latest earnings call:
We see a great market to invest, and we've been driving cap rates up, and we are actively engaged with our relationships to deploy capital at accretive spreads. And so we are by no means sitting on our hands and not taking advantage of the dislocation in the capital markets. On the contrary, we see a great opportunity for us to put capital to work at accretive spreads.
Thanks primarily to the rent escalators included in nearly all outstanding contracts, EPRT during the latest quarter has once again achieved positive same-store rent growth of 1.2%. This was slightly lower than the 1.5% achieved the previous quarter when a gym operator in Oregon filed for bankruptcy, which impacted two properties for which the company did not collect rent. During the conference call management has directly blamed longer pandemic restrictions in Oregon compared with the other markets they operate in, which have brought irreparable damage to this specific customer's financial health. Luckily there is no indication that this might be more than a tenant specific event as the unit-level rent coverage of other tenants operating in the same industry stands at 2.1x.
This event also highlights an important risk-mitigating principle adopted by management which is tenant diversification. As per the latest quarter, the largest tenant (Equipment Share) only represented 3.3% of the Annualized Base Rent. From the latest earnings call:
Our largest tenant, equipment share represented 3.3% of ABR at quarter end, and our top ten tenants continue to demonstrate the diversity in our portfolio, accounting for just 17.8% of our ABR. As we've consistently stated, portfolio diversity is an important risk mitigation tool for us and a product of our differentiated investment strategy, a direct benefit of our focus on non-credit rated tenants and middle market operators, which offers an expansive opportunity set and in our view generates superior risk-adjusted returns.
Thanks to the positive growth EPRT was able to raise their dividend twice during 2023, in June and September both times by 1.8%. The current dividend yield is 4.4% with a healthy FFO payout ratio of just 63%.
Valuation and key takeaways
EPRT's stock is currently trading at about 14.5x Forward Price to Funds From Operations ("FFO"), in line with some of its peers (Realty Income ( O ) 14x; Agree Realty (ACD) 16x; Four Corners Property Trust ( FCPT ) 15.4x). Despite this, the company is achieving higher AFFO growth than any other competitor.
Historically EPRT has been trading between 20x and 28x Price to FFO, substantially higher than current levels. I happen to think that we're probably not going to see similar valuations again anytime soon as I don't believe rock-bottom interest rates are in the cards for this decade as they have been for the past 13 years or so. What I mean by this is that investors should consider a potential investment in EPRT primarily for potential FFO growth and dividend growth, without hoping much in valuations improving. EPRT at the moment is valued at the top of their segment for good reasons, without reaching outrageous levels: that seems like a good position to be in my opinion.
I like EPRT a lot and since my last article I started to build my position slowly. I am aware that severe recessions might impact the company more than others given their exposure to small to mid-size tenants, but the flip side is that small tenants leave more room for growth in case things go well. Incidentally, things have gone pretty well since the company's IPO and I don't see any sign of things turning anytime soon. For this reason, I see myself keep adding to my position well into 2024.
For further details see:
Essential Properties Is One Of The Best REITs Out There