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Spirit Realty Capital (NYSE:SRC)

Q4 2013 Results Earnings Conference Call

February 27, 2014, 05:00 PM ET

Executives

Michael A. Bender - Senior Vice President and Chief Financial Officer

Thomas H. Nolan Jr. - Chairman and Chief Executive Officer

Peter M. Mavoides - President and Chief Operating Officer

Analysts

Vincent Chao - Deutsche Bank

Chris Lucas - Green Street Advisors Inc.

Vikram Malhotra - Morgan Stanley

Alexander Goldfarb – Sandler O’Neill

Wes Golladay - RBC Capital Markets

Christopher Lucas - Capital One Securities

Dan Donlan - Ladenburg Thalmann

Operator

Good afternoon ladies and gentlemen and welcome to Spirit Realty Capital's Fourth Quarter and Full Year 2013 Results Conference Call. At this time, all lines have been placed in listen-only mode. After the speakers' remarks there will be a question-and-answer period. (Operator Instructions)

This conference call is being recorded and a replay of the call will be available for one week beginning at 6 PM Eastern Time today. The dial-in details for the replay can be found in today's press release. Additionally, there will be an audio webcast available for the next 30 days on Spirit Realty Capital's website.

It is now my pleasure to turn the call over to Michael Bender, Executive Vice President and Chief Financial Officer of Spirit Realty Capital. Mr. Bender, please proceed.

Michael A. Bender

Thank you Regina and good afternoon everyone. Thank you for joining us today. This past year was transformative for Spirit and we are very pleased with the significant progress we've made since our IPO in September of 2012.

We’re in a great position to deliver value to our shareholders by continuing to execute our proven strategy of focusing on operationally essential triple net properties leased to middle market tenants.

Here with me today to discuss our fourth quarter and full year 2013 performance are Tom Nolan, our Chairman and Chief Executive Officer, and Pete Mavoides, our President and Chief Operating Officer.

Tom will start with some introductory remarks and highlights. I’ll then provide some color on our fourth quarter and full year 2013 financial results. Pete will then discuss our portfolio and investment program, and Tom will conclude with summary remarks prior to the Q&A portion of the call.

I would like to note that during this conference call, we will make certain statements that may be considered to be forward-looking statements under federal securities law. These statements are based on management's current expectations and the company's actual future results may differ significantly.

In our periodic reports on file with the SEC, we set forth certain factors that could cause our future results to vary from management's forward-looking statements. All information presented on this call is current as of today, February 27th, 2014, and Spirit does not intend and undertakes no duty to update forward-looking statements unless required by law.

In addition, reconciliations of non-GAAP financial measures presented on this call such as FFO, AFFO, and FAD can be found in the company's earnings release from earlier today, which is available in the Investor Relations section of our website. And with that, here is Tom.

Thomas H. Nolan Jr.

Thank you Mike, and thank you everyone for joining us today. We’re pleased with our results for the fourth quarter, our first full quarter after the closing of our merger with Cole II and for the full year 2013.

Spirit Realty is poised to grow both organically and through accretive transactions. We have the right team with energy and experience, a time-tested strategy, and a solid and coherent capital structure that will allow us to optimize our portfolio and to invest in properties that we believe will generate attractive and predictable growth.

Throughout 2013, we have shown that we can invest in a disciplined fashion and grow the portfolio rationally with a good risk-to-return profile. We've recycled capital as appropriate and we continue to successfully structure our leases, so that they meet our tenants' operational needs, while providing us with sustainable returns.

We also strengthened our balance sheet in 2013 by expanding our liquidity through a new $400 million revolving credit facility, issuing $330 million of investment-grade rated asset backed notes, and fixing the term and interest rate of variable short-term debt assumed in the Cole merger through a $203 million CMBS offering.

The $330 million note offering is of particular importance because it demonstrates that we have all the tools we need to assess lower cost investment-grade financing, while maintaining the flexibility to manage our assets.

In the fourth quarter of 2013, we completed the sale of five properties we identified as non-core, generating proceeds of $112.7 million. These transactions further demonstrate our strategy of focusing on what we know best, investing in operationally essential real estate is primarily for small and middle market tenants on the long-term triple net lease structures.

We acquired 114 properties in the fourth quarter for a gross investment of $235.4 million, in 19 transactions with an average remaining lease term of 16.7 years, earning a weighted average initial yield of 7.83%. We continue to see attractive opportunities that meet our investment standards.

Finally, we’re proud to say that these accomplishments have benefited our shareholders. We declared cash dividends for the fourth quarter 2013 of $0.16625 per share, an increase of 1.3% and 5.8% over dividends paid for the fourth quarter 2012 to pre-merger Spirit Realty Capital and Cole II shareholders respectively. The fourth quarter 2013 dividend equates to an annualized dividend of $0.665 per share.

The strong results reported for the fourth quarter and full year 2013 demonstrate our proven ability to generate cash flow and rationally grow our portfolio. The merger with Cole II benefited our company greatly, by diversifying our tenants’ space, enhancing our credit quality, improving our operating efficiency, reducing our leverage, and providing additional financial strength and flexibility in part by almost doubling the size of Spirit. We have a strong platform in place to continue our strategy and to deliver sustainable attractive returns to our shareholders.

I'd like to close my introductory remarks by thanking the team here at Spirit. It was a busy year and everyone has done a terrific job, and I know that even better things are yet to come in the months and years ahead.

With that, I’ll turn things back over to Mike who will walk you through the financial highlights for our fourth quarter and full 2013 results. Mike?

Michael A. Bender

Thank you, Tom. As Tom mentioned, we’re pleased to report strong results in our first full quarter following the closing of our merger with Cole II. I'll start by giving highlights of our financial results for the fourth quarter.

In the fourth quarter ended December 31, 2013, we generated total revenues of $139.2 million, nearly doubling the revenues reported in the fourth quarter of 2012, due largely to the impact of the merger. New investments and contractual rent growth offset the temporary reduction in revenues caused by our strategic divestitures and capital recycling activities.

Net income attributable to common shareholders for the fourth quarter of 2013 was $43.6 million or $0.12 per share based on 369 million average shares of common stock outstanding compared to the net loss attributable to common shareholders for the fourth quarter of 2012 of $5.2 million or $0.03 per share based on 159 million share average shares outstanding. The fourth quarter's results this year included $35.7 million in gains from the sale of property.

General and administrative expenses in the fourth quarter ended December 31, 2013 increased to $9.8 million from $6.2 million in the fourth quarter 2012. The increase is principally due to the cost of added infrastructure and headcount to support portfolio growth from the merger and organic acquisitions. On a relative basis, fourth quarter 2013 G&A expenses represented 7.0% of revenues, an improvement from the 8.8% reported in the fourth quarter of 2012.

Property cost increased to $5.4 million in the fourth quarter of 2013 and includes $3.4 million of reimbursable costs for which offsetting revenues were reported. Impacted by the merger, depreciation and amortization costs increased to $59.2 million in the fourth quarter of 2013 compared to $26.8 million in the fourth quarter of 2012.

Funds from operations for the fourth quarter 2013 were $68.4 million or $0.18 per share compared to $31.3 million or $0.20 per share for the fourth quarter of 2012. Adjusted funds from operations or AFFO for the fourth quarter 2013 totaled $70.6 million or $0.19 per share compared to $34.9 million or $0.22 per share for the fourth quarter of 2012.

As we have stated in the past, we believe AFFO is an important metric for investors to track because it adjusts FFO to eliminate the impact of nonrecurring items that are not reflective of the ongoing operation and non-cash items that reduce or increase net income in accordance with GAAP.

Moving on to the full year of 2013, total revenues for the full year ended December 31, 2013 increased 53.6% to $419.5 million compared to the prior year. The growth in total revenues was principally the result of an increase in rental income due to the merger.

Net income attributable to common shareholders for the year ended December 31, 2013 was $1.7 million or less than $0.01 a share based on 255 million average shares outstanding, compared to the net loss attributable to common shareholders for the year ended December 31, 2012 of $76.3 million or $0.97 per share based on 79 million average shares outstanding.

Note that the historical shares outstanding have been adjusted by the merger exchange ratio, as detailed in Spirit Realty Capital's public filings with the Securities and Exchange Commission regarding the Cole II merger.

G&A expenses incurred in the full year 2013 were $35.9 million, slightly lower than 2012. For the full year 2013, property costs were $11.8 million compared to $5.2 million in 2012.

Again, the increase in property costs is the result of several leases acquired in the Cole II merger, the terms of which require that we initially incur certain expenses that are billable and subsequently reimbursed by the tenants. In that regard, the $11.8 million in total property costs for 2013 include approximately $6 million of such reimbursable costs.

Depreciation and amortization cost for full year 2013 increased to $164 million from $105 million in the prior year, largely due to assets acquired in the merger.

Interest expense increased to $52.9 million and $179.3 million in the fourth quarter and full year 2013 respectively. Again, the increases in interest expense over 2012 are largely due to the assumption of debt in connection with the Cole II merger.

For the year ended December 31, 2013, FFO was $139.5 million or $0.54 per share compared to $52.8 million or $0.57 per share for the prior year. For the year ended December 31, 2013, AFFO was $208.9 million or $0.81 per share compared to $119.2 million or $1.14 per share for 2012.

Remember that the average shares outstanding in 2012 were reduced because the IPO did not occur until later in the year.

Although cost for the fourth quarters of 2013 and 2014 were only minimally impacted by the merger and the IPO respectively, full year results in both 2013 in 2012 include significant non-recurring cost and expenses.

For the year December 31, 2013; first, amortization charges included in interest expense arising from financing commitments were $10.1 million. Two, transaction costs included in merger costs were $52.5 million. And three, third party expenses incurred to solicit and obtain lenders' consent to the merger also included in property cost totaled $4.1 million.

For the full year ended December 31, 2012, IPO costs included $4.7 million and term loan extinguishment was $41.2 million. Still, absent these merger, IPO and associated term loan extinguishment charges, net income attributable to common shareholders was $68 million or $0.27 per share for the full year 2013, compared to a loss of $30.3 million or $0.39 per share for the full year 2012.

For the three months and year ended December 31, 2013 dividends declared to common stockholders of $61.6 million and $169.4 million represented a 90% and 82% payout ratio dividend funds available for distribution, or FAD, generated during those respective periods.

As we detail in our earnings release, we define leverage as debt reduced by cash and cash lateral balances divided by annualized quarterly EBITDA adjusted for one-time items. Based on that definition, our leverage was up slightly at December 31, 2013 to 7.3 times compared to 7.2 times at December 31, 2012. Year end 2013 was up slightly as we had just received $330 million in ABS bond issuance proceeds in December that Tom alluded to.

Conversely, year end 2012 was down slightly as a result of IPO equity proceeds received late in that year. As we have noted previously, we expect our portfolio to de-lever over time in part because most of our debt is amortizing. Contractual amortization payments are scheduled to reduce our outstanding debt amount by $114.6 million prior to December 31, 2015.

Moving to guidance, we’re pleased to affirm our previously announced 2014 AFFO guidance in the range of $0.77 to $0.82 per share.

I would now like to turn the call over to Pete to review our operations. Pete?

Peter M. Mavoides

Thanks Mike. As illustrated by Mike and Tom's comments, our portfolio is in great shape and performing well. We continue to look to optimize the portfolio by driving organic growth, recycling capital as appropriate, and making accretive acquisitions, all with the goal of delivering stable and predictable cash flows that support our dividends. We’re disciplined investors and experienced operators and these attributes continue to serve us well in 2013.

I will start with an overview of our portfolio. We build and manage our portfolio expecting to yield attractive growth prospects over the life of the underlying leases.

As of December 31, 2013, our gross investment in real estate and mortgage and equipment loans totaled $7.2 billion, substantially all of which was invested in 2,186 single-tenant properties that were 99% occupied.

Our properties are generally leased under long-term triple net leases, with a weighted average remaining maturity of approximately 10.1 years.

At December 31, 2013 approximately 43% of our annual rent, defined as annualized fourth quarter contractual rent, is contributed from properties under master leases and approximately 86% of our single-tenant properties provide for annual rent increases.

As part of our active management and monitoring of risk, we continue to receive unit level financial statements for approximately 50% of our tenants. For Spirit's reporting tenants, the average unit level rent coverage for the trailing 12 month was 2.8 times. This compares favorably to 2.7 times for the same period a year ago.

As you know, we do unit level rent coverage as a valuable indicator of how essential our properties are to their tenants' operations and their ability to pay rent. Approximately 62% of our tenants that do not provide unit level financial statements are investment grade quality.

Through the merger and our continued focus on portfolio diversity, we made good progress on reducing our tenant and geographic concentrations. For example, our real estate portfolio as of December 31, 2013 was diversified across 48 states and among various industry types.

One state, Texas, accounts for 13% of our annual rent contribution of the real estate portfolio and no other state contributed more than 7%.

Additionally for the fourth quarter, ShopKo's contribution to total revenue dropped to 15% from 29% for the same period in 2012. Our three largest industry types based on annual rent as of December 31, 2013 were specialty retail at 19%, general and discount retail at 18% and quick serve restaurants at 10%.

Moving on to new investments, we acquired 114 single-tenant operationally essential properties with the gross investment of $235 million in 19 separate transactions during the fourth quarter of 2013.

These investments had initial cash yield of 7.83% and deal with seven existing and 12 new tenants. On average, the associated leases have a remaining lease term of 16.7 years.

Acquisitions in the fourth quarter of 2013 more than tripled the volume for the fourth quarter of a year ago of $77 million in 33 properties. These investments were generally consistent with our strategy of investing in small portfolios of granular properties, where there's decreased competition from large investors seeking to deploy significant amounts capital and the retail investors focused on acquiring properties on a one-off basis.

Also consistent with our strategy, approximately 60% of the investments during the quarter were direct sale leaseback transactions, where we acquired the properties and the transaction structure directly with the tenant.

For the full year, excluding the Cole II merger, we acquired 194 new properties for a gross investment of $408.6 million in 40 separate transactions with a weighted average lease term of 16.8 years earning an initial cash yield of 7.92%, which is more than double, $164 million invested in 91 real estate properties during the year prior. For the full year, approximately 60% of the investments were direct sale leaseback transactions.

As Tom and Mike alluded to, we continue to selectively sell assets and recycle the proceeds consistent with our investment strategy. During the fourth quarter of 2013, we sold five properties, generating gross sales proceeds of $113 million.

During the year ended December 31, 2013, we sold 21 properties generating gross sales proceeds of $392 million. These property sales were completed at a weighted average lease cap rate of 7.1% with leases in place that had a weighted average remaining term of 6.8 years. These were high quality profitable properties, but were not consistent with our core investment strategy.

In late December, we established a securitization platform to support our financing activities relating to commercial real estate, net leases and mortgage loans. In establishing this platform, a subsidiary of Spirit issued $330 million of net lease mortgage notes allocated between two series, both A-plus rated by S&P and Kroll. This transaction locks in attractive long-term financing and increases our financial flexibility as we continue to focus -- as we continue our focused investment strategy.

And with that, I'll turn it back to Tom.

Thomas H. Nolan Jr.

Thank you, Pete. Once again we’re pleased with all that we've accomplished since our IPO in September of 2012. And we’re looking forward to continuing our positive momentum. We’re entering 2014 with financial strength and flexibility and with a clear strategy to continue to deliver attractive and sustainable returns for our stockholders.

We remain focused on a clear strategy that balances organic growth, accretive acquisitions with steady predictable cash flow, which has served our stockholders well over the past years and we believe will continue to do so over the near and long-term.

As always, we appreciate the support we receive from our shareholders and look forward to remaining in touch with all of you as we move forward.

We’re now happy to answer your questions.

Question-and-Answer Session

Operator

(Operator instructions) And your first question today comes from the line of Vincent Chao with Deutsche Bank.

Vincent Chao - Deutsche Bank

Hey everyone. Just curious if you could make some comments on the acquisition pipeline. It sounded like things were still looking pretty good there, but just curious how the pipeline has changed over the last quarter or so?

Peter M. Mavoides

Yeah, hello, this is Pete speaking. We’re very optimistic about the pipeline we have in front of us as you can tell in the numbers disclosed, we had a very active fourth quarter and we would anticipate a similar level of activity going into the first quarter.

Vincent Chao - Deutsche Bank

Okay. And for the full year, I mean do think the 2013 level is reasonable -- I mean obviously excluding the Cole merger?

Thomas H. Nolan Jr.

Well, as you know, we don't provide guidance on acquisitions. I simply just never believed in that and rather would continue to announce results that we believe are attractive and appropriate, but I would echo I think Pete's comment that the acquisition market at this point is pretty balanced.

There is certainly lots of capital out there we all know that, but there are also a lot of investment opportunities out there and we've got a substantial amount of investment opportunities that we’re looking at. So, I think absence some change in the capital markets or some other market, I think we’re optimistic that we’re going to continue to see and report an attractive acquisition activity.

Vincent Chao - Deutsche Bank

Okay. And just looking at the cap rates here the last couple quarters, seems like stabilized year and what you bought last quarter and this quarter, are you seen much on the in the way of upward pressure on cap rates or downward for that matter?

Michael A. Bender

You know we reported 792 for the year and 783 for the fourth quarter, so clearly you can see some minor downward trend there. That trend has continued into the first quarter, but again if that's the margin, it really depends upon the mix of yield that we do and any one given quarter, but we’re generally looking at the stable cap rate environment.

Vincent Chao - Deutsche Bank

Okay. Thanks guys.

Thomas H. Nolan Jr.

You're welcome.

Operator

Your next question is from the line of Chris Lucas with Green Street Advisors.

Chris Lucas - Green Street Advisors Inc.

Hi guys. Just one question. Over the past couple quarters you've been kind of rebalancing your portfolio. As it stands today, is the portfolio where you would like to be, or are there still a number of non-core property tax that you're looking to sell?

Thomas H. Nolan Jr.

Thanks Chris. And I just I would start at the top by saying overall we’re very happy with where the portfolio is. We like our portfolio. We like how it's performing and the recycling is really -- has two major components to it.

The first is that we identify certain assets in the Cole’s portfolio that we were going to be selling out over time as the -- as in some cases as the debt -- period allowed us to do. And a lot of the disposition is off since the merger closed related to previously identified assets.

But then we also have a very rigorous portfolio management process that we go through where we’re looking at assets and if we see assets that we believe are no longer meeting our criteria, we’re going to move up on them.

But I would not describe that as hugely material at this point. I think we’re always going be identifying those who you're going to be looking at those, but I think in general, when you look at the portfolio statistics that Pete referred to both our occupancy levels and our coverage levels, I think we’re very pleased with the composition of the portfolio, we like the diversification. And I would expect that the dispositions that you see will again not be hugely material.

Chris Lucas - Green Street Advisors Inc.

Understood. Thanks. And then just in terms of spin on our dispositions, could you provide any color disposition cap rates for the fourth quarter?

Michael A. Bender

We didn't provide them on the quarter; we provide them on the year. We sold some multitenant properties during the quarter and they were in the low sevens and we sold the Camelback during the quarter and that was in the mid-eights.

Chris Lucas - Green Street Advisors Inc.

Got it. And then just one last question. There’s been a general softness in retail over the past quarter, what's been the kind of feedback from your tenants as far as kind of what they're seeing?

Michael A. Bender

As we reported in the quarter, our stats have generally trended up and so from a credit perspective, our tenants are relatively looking a little bit healthier. Clearly, we don't have year-end numbers in for all our tenants, but we would expect you know that some of the retail softness that hit other tenants that have reported would impact like contents in our portfolio. But in general, the credit statistics are pretty positive as we see today.

Chris Lucas - Green Street Advisors Inc.

Thanks a lot. Appreciate it.

Michael A. Bender

Yeah, Chris, thank you.

Operator

Your next question is from the line of Vikram Malhotra with Morgan Stanley.

Vikram Malhotra - Morgan Stanley

Hi guys. Just one quick question. As you look to reduce exposure to ShopKo maybe just gradually, how does -- if the company’s opening up say a few stores, is that something that you're talking to them about or is it that your intention to just acquire in other areas, so that you can kind of reduce the ShopKo concentration?

Michael A. Bender

Yeah, I think we -- ShopKo is opening stores. I don't think we would have appetite for increased exposure to them. And not because there's anything specific to their credit, but purely from an exposure perspective. Our goals are to reduce that. So -- and there's plenty -- as we discussed earlier, there's plenty of opportunities out there outside of ShopKo. So, I think we’re trying to work that exposure to the other directions and I’m sure there's plenty of capital providers out there for them.

Vikram Malhotra - Morgan Stanley

Maybe just you can give a quick update on as you go through the year, your plan overall for funding some of the new acquisitions, how are you viewing your cost of equity, overall cost of capital, and just kind of give us an update on funding?

Thomas H. Nolan Jr.

Sure. Happy to without getting I guess into too much of speculative. I mean we’re -- this is a spread investing business and we’re looking at the acquisition opportunities that we have with a relative capital structure that we can put together.

And if we continue to see the acquisition market we have in front of us, we would expect that we will be an acquirer and that we will be putting in capital structure in place that provides an accretive returns through a combination of capital that we have available to us today, because we have an uninvested capital and have access to lines of credit.

And then we have really the whole kind of panoply of options available to us that many companies such as ourselves have through various forms of equity down the line. But again that will be -- it could be preferred equity, it could be equity, it could be any element of that, but that will be a judgment at the time.

Again based on capital markets, our cost of equity, our acquisition pipeline, our acquisition rates of return. So, at the moment, as we’re sitting here we have dry powder we don't need to do anything. We can certainly continue to invest and meet our pipeline without doing anything and then what we do is really going to be facts and circumstances driven at the time that we face that.

Vikram Malhotra - Morgan Stanley

Thanks guys.

Thomas H. Nolan Jr.

Thank you.

Operator

Your next question is from the line of Alexander Goldfarb with Sandler O’Neill.

Alexander Goldfarb – Sandler O’Neill

Good afternoon. Hey, how are you? It’s just want to go first to the ABS, I mean is it just that simple to say basically all the CMBS debt that you guys have maturing overtime and mortgage debt that you guys have maturing overtime, any of that debt that you didn’t want to pay off for cash, you could essentially warehouse some of your line of credit and then issue ABS against it. So effectively, you could make the company sort of quasi investment grade overtime, is that a way to think about it?

Peter M. Mavoides

That's part of the way to think about it. The ABS facility has certain concentration tests as to tenancy and geography industry. And so it's not as if we could plough the entire ShopKo exposure into an ABS execution, but we could certainly find some home for some of that in the ABS pool.

Thomas H. Nolan Jr.

And the way I look at it Alex is that I mean I just think it’s attractive to have options. You want to create as much optionality as you can in your available capital structure and I just think it's very attractive for Spirit to be able to go and look and say which asset is best suited where can we get the best cost of capital and that best cost of capital conceivably could be a CMBS fixed rate offering that's particularly useful on some of our larger assets. And I think we could be doing that when some of these maturities rollover.

But the half of flexibility of using this investment grade vehicle with its wonderful flexibility of swapping assets in and out and its very efficient for raising money for the smaller assets where the CMBS offerings were quickly done, but they tended to be inefficient and more expensive.

So, I just like the flexibility. As I look at it today, we've got our line which is a typical line. We have the ABS which is an investment grade product and we have the CMBS, which is a fixed rate product. And we can just look into the capital markets and pick where we can find the best efficiency and the best price of money.

Alexander Goldfarb – Sandler O’Neill

Okay. Okay that makes sense. That's helpful color. Next, I don't think you mentioned that your finance book that you have, can you just provide an update of what the balance is and what the payoff schedule is? So we know you outline the amortization of your mortgage debt, but sort of curious, the amortization of the finance book.

Michael A. Bender

Our mortgage loan, I think it's -- on the asset side Alex?

Alexander Goldfarb – Sandler O’Neill

Yeah. Where you guys own loans that you're collecting the interest.

Michael A. Bender

Yeah, this is pretty -- I think you can kind of see the run rate off the historic -- and its down. I can't remember the remaining life off hand, but it is -- amortizes down about as it has over the last few quarters.

Alexander Goldfarb – Sandler O’Neill

Okay. Okay, that's fine. I didn’t know if there was any -- people were paying off stuff quicker, if there was any change in prepay or anything.

Michael A. Bender

Yeah, no. Really have not had much prepayment, it’s just running off kind of as scheduled and as you probably know haven't added to that portfolio in a while.

Alexander Goldfarb – Sandler O’Neill

Okay. And then just the final question is, you mentioned in response to one of your earlier questions, the cap rate basically haven't changed. But if we think back over the past year, I mean everyone went sort of -- the market went crazy went crazy when Bernanke spoke.

Now, the tenure year has backed up -- sorry has tightened once again. So through this whole sort of nine month process where people were thinking that tenure was going to go to 3, 3.5, and now we're backed down below that. You're saying that through that whole time, as you guys look at properties and assets, there was never any sort of change in the cap rate thinking or the cap rates that the market was applying to the different assets that you're looking at?

Peter M. Mavoides

No, no. I merely pointed out that our acquisition cap rate for the year was 10 basis points higher than our acquisition cap rate in the fourth quarter. We certainly saw a lot of downward pressure on cap rates in the end of the first quarter going into the second quarter and backing up against Bernanke’s comments.

There was a lot of liquidity, but coincidentally at the period of time where we were not very active in acquisitions as we are focused on closing whole transactions. So, we certainly within the year, we saw some cap rate movement.

Just so happened that our numbers were reflected not a lot, but we’re as investors and Tom said as spread investor, we’re very cognizant to the underlying financing cost of our investments and then you know price that into where we look at deals.

Thomas H. Nolan Jr.

And I would only offer that our experience is that the treasury yields move every day, move every hour, sometimes more violently than others and cap rate cap rates tend to move much slower. And again my experiences when you get real significant volatility in interest rates as we got when Bernanke was speaking, what tends to happen is people freeze up a little bit and say I was just -- let me see where this is going to settle out and the transaction volume tends to slow a little.

But over time -- and there has been a long history here in this business now, over time cap rates in these interest rates are correlated. They are just correlated once reacts more slowly than the other.

Alexander Goldfarb – Sandler O’Neill

But basically to your comments about your appetite for acquisitions, it seems that if people are getting sort of more comfortable with interest rates in the tenure that obviously then seems to bode well. So, I mean we could see some pretty good acquisition opportunities in this year?

Thomas H. Nolan Jr.

Yeah. Again I think if you Capital Markets Day, and the acquisition climate remains in terms of sellers’ objectives, yes I think we could. I think we’re pleased with what we see in front of us. But, again, we’re always cognizant that in our business, you need to be able to react, if in fact, facts and circumstances change, because right now, I think we like the types of investment opportunities that we're seeing.

Alexander Goldfarb – Sandler O’Neill

Okay, great. Thanks a lot.

Thomas H. Nolan Jr.

You’re welcome.

Operator

Your next question is from the line of Wes Golladay with RBC Capital Markets.

Wes Golladay - RBC Capital Markets

Hey, good afternoon guys. When you look at the competition for assets, are you guessing any looseness in the terms of the deal whether the coverage or rental bumps, I mean how is that looking right now?

Michael A. Bender

There is competition. We’re certainly seeing our fair share. Two stats I’d like to point to is the percentage deals that came from relationship tenants where we have an inside track and then the percentage deals where we’re structuring direct sale leasebacks and have the ability to you know said pricing set lease terms and both of those percentages were high during the quarter and the year and we’re -- so again not to sound like a broken record, but we’re pretty optimistic and bullish on the deals that we've done and the deals that we see in front of us.

Wes Golladay - RBC Capital Markets

Okay. And what is the difference between pricing, the relationship deals than new small portfolios kind of large portfolios that are of the right now?

Michael A. Bender

You know it’s hard -- I guess I would just point to our average cap rate is 79 for the year, which is all small bite sized portfolios. And then you can look at the larger transactions that traded in the year and they tended to trade around a seven cap and would diversified and some others were out there. And so it seems like there's a decent premium, but don't read too much into that, because there's different quality, different asset, there's debt and play but there's some premium.

Wes Golladay - RBC Capital Markets

Okay. Thanks a lot.

Operator

(Operator instructions)

Your next question comes from the line of Chris Lucas with Capital One Securities.

Christopher Lucas - Capital One Securities

Good afternoon guys. Thanks for taking my questions. Just a quick question on the acquisition environment. I guess I was hoping that I could get a better color from you guys in terms of what it's like in terms of the flow that you're seeing, so if you could give us a sense as to what level of deal flow you were underwriting fourth quarter or for all 2013, that would be helpful.

Thomas H. Nolan Jr.

I guess I may disappoint you with this answer, but I again I don't -- we don't like to -- we don't provide guidance on acquisitions. And I for one also never been a huge believer in discussing how much you look at versus how much you did.

And I know that's a statistic, that does come up from time-to-time and we reviewed x trillion dollar of deals and we only did so many. And I've never quite been able to read much into that when I sat on the other side of the table.

So, now that I sit on the side of the table, I really -- I think I hope we gave you a perspective that we do think the acquisition market is attractive at the moment and that we’re seeing good opportunities. But it really isn't a statistic that we put much weight on and terms of how many we looked at, much more focused on what we've done and the performance of the ones that we've done.

So, that may not be the answer that you were looking for, but again, I think we at the moment think that this -- that the acquisition market is attractive and we’re active in it.

Christopher Lucas - Capital One Securities

So, let me try another way then. You guys had talked about the direct sourcing deals and the existing relationships. Is there any component of your acquisition flow that is either coming from -- that's coming off of a broker-led transaction or is it all coming in the other directions?

Michael A. Bender

Certainly, we deal with brokers and advisors and the intermediaries and healthy part of our deal flow comes from them. We also have 300 plus tenants and a good portion of our deal flow comes from them.

And so -- and then we have a direct calling effort where our originators are directly calling on new tenants and sourcing deals there. And that mix changes in any given quarter, in any given year, but generally we’re sourcing opportunities from all three of those channels.

Christopher Lucas - Capital One Securities

Okay. And then a question about the quarter’s acquisitions, the average property size was very small roughly $2 million. Was that of focus for you guys or is that something just how the fourth quarter fell out?

Michael A. Bender

No, we focused on small granular properties and if you look at our portfolio of $7.2 billion across 2,100 properties that average property size is 3 million-ish. And so -- while it's a little below the average in the quarter, that's where we tend to focus.

Christopher Lucas - Capital One Securities

Okay. And then just in terms of product out between office and retail and distribution, is there any bias that you have as it relates to that product type?

Michael A. Bender

Yeah, the first thing we always hang our hat on is the operational essentiality of the real estate where we can understand the tenant's ability to generate profits in that property because that's where we find our tenants are very sticky and reliable. Our overall portfolio is roughly 80% retail. I would suggest that indicates a bias towards retail and the quarter -- the investments in the quarter generally match that.

Christopher Lucas - Capital One Securities

And then the last question is a housekeeping question. I was just looking at the top tenant list third quarter to fourth quarter, and the number of Church’s Chicken's property drop by 37, is there something there that I’m not understanding?

Thomas H. Nolan Jr.

No. I don't have that in front of us. So, we’ll follow-up on that, but no.

Christopher Lucas - Capital One Securities

Okay. Thank you guys.

Michael A. Bender

Thank you.

Thomas H. Nolan Jr.

You're welcome

Operator

Your next question is from the line of Dan Donlan with Ladenburg Thalmann.

Dan Donlan - Ladenburg Thalmann

Thank you, and good afternoon. Just going back to the question -- good afternoon. Just going back to the question on ShopKo, just curious how many new stores are they opening up this year and are they going to be leased to third-parties or are these going to be company-owned stores?

Michael A. Bender

Dan, we -- I don't know ShopKo's plans nor if I did would I necessarily be able to disclose them. We generally speak to individual tenants. What I will say is ShopKo executed the merger with Pamida which they articulate at the time was designed to create growth opportunity in the smaller box, their ShopKo hometown. And I would anticipate that being part of a growth channel to them. And I can't really speak to how many or how they are going to capitalize them.

Dan Donlan - Ladenburg Thalmann

Okay, appreciate it. And then as far as acquisitions that you're looking at for this year, how do you feel about investment grade versus non-investment grade is that really a consideration for you? And then lease bumps; is that a big criteria for you as well?

Michael A. Bender

At the time of our IPO, Dan, we were 1% investment grade rated. And that was actual investment grade tenancy. And so on a historic basis, Spirit has focused generally on the unrated tenants. The tenants may very well have an investment grade quality financial picture, but for whatever reason to not carry a rating most likely because of the size and the no need without publicly-traded debt.

So, our core investment business discipline really focuses away from investment grade tenants where we find there to be hyper competition and downpours. Eventually where we feel we get a better risk return on our investments.

In terms of rental growth, we disclosed in our quarter that 80% -- 86% of our leases contain contractual rent escalations and rental growth is an important component of our investment thesis.

The rental growth over 15 or 20-year lease can change your initial cap rate to GAAP cap rate of about 100 basis points. And so we’re focused on growing our AFFO per share and important part of that is having internal growth within our portfolio. So, that's a strong consideration as we look into investments.

Thomas H. Nolan Jr.

And just to embellish on that Dan a little bit. At the time of the IPO when we were doing the Roadshow, I think one of the -- we touched on this point quite extensively and I think the point that we made at the time that it was our belief that the just below investment grade -- investment opportunity is displaced in our view off of the best risk adjusted return opportunities.

It was our belief that just for that small amount of incremental credit differential, the difference between an investment grade BBB and a non-investment grade BB whether they were invested, whether they had an investment rating or a shadow rating, it was our view that that relatively small differential and credit offered in outsized investment performance opportunity.

You've got a better cap rate and you've got other terms. Rent bumps being one of them. That is one of the challenges of buying from investment grade tenants is you tend to get flatter leases.

And so our -- we want to be incorporating that organic growth in our portfolio and generally, from the non-investment grade tenants, you are able to attract those. And plus you get other benefits such as master leases and other components, but again, you do not get an investment grade.

So, obviously, capital market conditions can change and a year from now, maybe the risk adjusted return on investment grade might be better than the non-investment grade. But at the time of the IPO, we felt strongly about and I think we continue to feel strongly about it. And that's the spot in the investment spectrum that we see the best way of suggested return.

Dan Donlan - Ladenburg Thalmann

Yeah. Not that it matters, but I completely agree with you. Thank you.

Michael A. Bender

Thanks Dan.

Thomas H. Nolan Jr.

Thank you.

Operator

Ladies and gentlemen, this concludes the question-and-answer portion of today's event. I’d like to turn the call back over to Tom Nolan, Chief Executive Officer for closing remarks.

Thomas H. Nolan Jr.

Thank you. And thank you once again for your interest in Spirit and for listening to our call today. We look forward to talking with you again soon. Good afternoon everyone.

Operator

Ladies and gentlemen, thank you so much for your participation. This concludes the presentation. And you may now disconnect. Have a great day.

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