STORE Capital's (STOR) CEO Chris Volk on Q2 2016 Results - Earnings Call Transcript

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STORE Capital (NYSE:STOR)

Q2 2016 Earnings Conference Call

August 4, 2016 12:00 ET

Executives

Moira Conlon - Investor Relations

Chris Volk - President and Chief Executive Officer

Cathy Long - Chief Financial Officer

Mary Fedewa - Executive Vice President, Acquisitions

Analysts

Paul Adornato - BMO Capital Markets

Vikram Malhotra - Morgan Stanley

Dan Donlan - Ladenburg Thalmann

Craig Mailman - KeyBanc Capital Markets

Ki Bin Kim - SunTrust

Tyler Grant - Green Street Advisors

Todd Stender - Wells Fargo

Chris Lucas - Capital One Securities

Collin Mings - Raymond James

Operator

Good day and welcome to the STORE Capital’s Second Quarter 2016 Earnings Webcast and Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Moira Conlon, Investor Relations for STORE Capital. Please go ahead.

Moira Conlon

Thank you, Allison and welcome to all of you joining us for today’s call to discuss STORE Capital’s second quarter 2016 financial results. Our earnings release, which we issued this morning along with a packet of supplemental information, is available on our investor website at ir.storecapital.com under News & Market Data, Quarterly Results.

I am here today with Chris Volk, President and Chief Executive Officer of STORE Capital; Cathy Long, Chief Financial Officer; and Mary Fedewa, Executive Vice President of Acquisitions. On today’s call, management will provide prepared remarks, and then we will open the call up to your questions.

Before we begin, I would like to remind you that comments on today’s call will include forward-looking statements under the federal securities laws. Forward-looking statements are identified by words such as will be, intend, believe, expect, anticipate, or other comparable words and phrases. Statements that are not historical facts such as statements about our expected acquisitions, our dividends, our AFFO and AFFO per share guidance for 2016 are also forward-looking statements. Our actual financial condition and results of operations may vary materially from those contemplated by such forward-looking statements. Discussion of the factors that could cause our results to differ materially from these forward-looking statements are contained in our SEC filings, including our reports on Forms 10-K and 10-Q.

With that, I would now like to turn the call over to Chris Volk. Chris, please go ahead.

Chris Volk

Thanks, Moira and good morning, everyone and welcome to STORE Capital’s second quarter 2016 earnings call. With me today are Cathy Long, our CFO and Mary Fedewa, our Executive Vice President of Acquisitions.

STORE continued its rapid growth rate in our second quarter, with acquisitions activity averaging slightly in excess of $100 million a month, resulting in total first half investments of $624 million net of our asset sales. Our portfolio remained healthy with an occupancy rate of 99.8%. And approximately 75% of the net lease contracts we rated, we rated investment grade quality based upon our STORE Score methodology.

Our dividend payout ratio continued to approximate 67.5% of our adjusted funds from operations serving to provide our shareholders with a well-protected dividend and a company that’s well positioned for long-term internal growth based upon anticipated tenant rent increases and the reinvestment of our surplus cash flows. Our funded debt to EBITDA on a run-rate basis was just under 6x at the end of the quarter with our unencumbered assets rising to more than $2 billion or close to 45% of our total growth investments providing us with flexibility in our financing options. In April, we employed our corporate BBB- rating for the second time, closing on $300 million in long-term unsecured borrowings. The proceeds of which were applied to repay our unsecured credit line.

As we discussed in our first quarter earnings call, this borrowing highlights the historically high investment spreads we have been able to realize and the stable long-term laddered borrowing maturities we are creating. Our laddered maturities, supported by free cash flows after dividend payments, will largely protect STORE from liability sensitivity in the event of rising rates or in the event that interest rates revert to more historic average levels. We expect our unsecured long-term borrowings – we expect our unsecured term borrowing initiative, which we undertook in 2015, to complement our A+ rated master funding conduit to the benefit of our noteholders and our stockholders.

As I have been prone to do on our quarterly conference calls, here are some statistics relevant to the second quarter. Our weighted average lease rate stood at approximately 7.8%. The average annual contractual lease escalations approximated 1.7% and weighted average primary lease term was approximately 17.5 years. The median new tenant Moody’s risk credit rating profile was BAA2. The median post overhead unit level fixed charge coverage ratio was approximately 2.4:1. The median new investment contract rating or STORE Score for the investments we made during the quarter was consistent at A1. We added 10 net new customers and expanded our profits and our assets to include 5 new industries, reflecting both a diversification strategy and the value proposition that we have across the industry sectors.

Our average new investment was made at approximately 82% of replacement cost. 89% of the multiunit investments we made were subject to master leases. All of the 115 assets we acquired during the quarter are acquired to deliver unit level financial statements, giving us unit level financial reporting from 97% of the properties within our portfolio. Our investment activity continued to be highly granular with 37 separate transactions completed at an average transaction size of $9.1 million.

Finally, at the end of the quarter, the proportion of revenues realized from our top 10 customers continued to be highly diverse at 16.6% of annualized rents and interests. Further, no single customer exceeded 2.4% of our annualized rents and interest. And with that, I will turn the call over to Mary.

Mary Fedewa

Thank you, Chris and good morning everyone. During the second quarter, we continued to see steady investment activity along with stable cap rates. Acquisition volume was $356 million, which is consistent with the same period last year and it is our second highest quarterly volume since inception. As Chris mentioned, our average lease rate for second quarter was 7.8%. Including our second quarter investment activity, our portfolio remains consistent across industry types with approximately 70% in service industries, 17% in retail and the remaining 13% in industrial assets. And 75% of our acquisitions continued to be our investment grade quality based on our STORE Score methodology.

We continue to add new customers and also generated a significant portion of new business from repeat customers. In fact, approximately one-third of our acquisitions in the first half of 2016 were from repeat customers. We believe this reflects our commitment to building strong relationships with our customers through our direct origination approach. Our acquisition pipeline continues to be robust and diverse and we are excited about the level of compelling investment opportunities we are creating across a variety of industries that will reinforce our diversified portfolio strategy. As I mentioned in our last call, we expect to sell selected properties during the year to take advantage of opportunistic gains and to balance our portfolio.

In the second quarter, we sold nearly $16 million of properties, achieving cap rates of approximately 100 basis points less than our acquisition cap rate for those properties. This demonstrates the market premium we are realizing as a result of the value we deliver to our customers. Also it’s important to note that the gains we are achieving on property sales serve to offset losses we may experience in the portfolio. As you saw in our press release, we have increased our 2016 acquisition guidance to $1 billion, net of any property sales, which we estimate will be $60 million to $80 million for the full year. Our third quarter is off to a strong start. As of the end of this week, we will have funded over $725 million in year-to-date gross acquisition volume.

With that, I will turn the call to Cathy to talk about financial results.

Cathy Long

Thank you, Mary. I will start by discussing our balance sheet and capital structure, followed by our operating results for the second quarter and our guidance for 2016. Please note that all my remarks refer to the second quarter ended June 30, 2016 and all comparisons are year-over-year, unless otherwise noted.

Consistent with prior quarters, our balance sheet and operating results reflect the continued growth of our portfolio through selective property purchases. Gross acquisition activity totaled $356 million during the second quarter and brought our year-to-date acquisition volume to $624 million, which is net of asset sales of $17 million. Our second quarter acquisition activity was funded through a combination of our recently expanded credit facility, long-term borrowings and a follow-on equity offering we completed in May. Through this equity offering, we sold 12.4 million shares of our common stock at a price of $25.60 per share raising more than $304 million in net proceeds, including the full exercise of the underwriters’ overallotment option.

With regard to borrowings, we issued $300 million in long-term unsecured debt during the quarter at a blended rate of 4.06%. This debt consisted of 10-year fixed rate senior unsecured notes at 4.73% and 5-year floating-rate unsecured bank term debt, which was effectively converted to a fixed rate of 2.73% through interest rate swaps. In June, we issued $65 million of fixed-rate non-recourse debt secured by approximately $100 million of specific properties. This debt bears interest at 4.75%, with a 30-year amortization due in 10 years.

Our second quarter borrowing activity brought our aggregate long-term debt outstanding at June 30, 2016 to $2.2 billion with a weighted average maturity of 6.6 years and a weighted average interest rate of 4.6%. At the end of the second quarter, our leverage stood at a conservative 5.9x net debt to EBITDA on a run-rate adjusted basis or roughly 47%% on a debt to cost basis. This level of leverage is slightly more conservative than the 6x to 7x range we gave last fall for our 2016 guidance. In anticipation of issuing public investment grade rated debt at some point in the future, we are transitioning to this more conservative level of leverage and are now targeting debt to EBITDA on a run-rate basis of around 6x, plus or minus 25 basis points going forward.

As of June 30, 2016, gross investment in our real estate portfolio totaled $4.6 billion, of which approximately $2.5 billion has been pledged as collateral for our secured debt. The remaining $2.1 billion of real estate assets are unencumbered providing us with flexible financing options to effectively manage our cost of capital. We entered the third quarter with ample liquidity, consisting of $119 million in cash and the full $500 million available on our credit facility, which can be expanded to as much as $800 million under the accordion feature.

Now turning to operating results, revenues increased 33% to $92 million, reflecting the strong growth in our real estate investment portfolio. Rental revenues made up about 95% of our total revenues, with the remainder largely attributed to interest income on mortgages and leases accounted for as direct financing receivables. At quarter end, our portfolio totaled $4.6 billion, representing 1,508 property locations, up from $3.5 billion gross investment, representing 1,175 property locations a year ago. The annualized base rent and interest being generated by our portfolio increased 32% to $382 million as compared to $290 million a year ago, with increased diversity by location, by industry and by tenant.

Total expenses increased 29% to $65 million compared to $50 million a year ago. The increase largely relates to the growth of the portfolio, with over half of the increase due to higher depreciation and amortization expense. For the quarter, interest expense increased 25% to $26 million from $21 million a year ago, as we continue to fund a portion of our acquisitions with long-term borrowings. This increase was slightly offset by a decrease in the weighted average interest rate on our debt.

Property costs increased to $1.2 million for the second quarter. The increase was largely driven by real estate taxes and other property carrying costs incurred on the three properties in our portfolio that were vacant during the quarter and included an accrual for real estate taxes, build in arrears on properties where we believe that the tenant may be unlikely to pay the taxes. These properties represent a very small amount, about 1% of the annualized base rent and interest generated by our portfolio. The amount of property costs can vary quarter-to-quarter based on the timing of property vacancies and the level of underperforming properties. However, we do not anticipate that such costs will be significant to our operations.

G&A expenses were $8.5 million in the second quarter compared to $7.2 million a year ago, primarily due to servicing costs and personnel related to the increased size of our portfolio and to an increase in non-cash equity based compensation. G&A expense as a percentage of portfolio assets decreased to approximately 74 basis points on an annualized basis compared to approximately 83 basis points a year ago. This was largely due to the benefits of efficiency and scale that come with portfolio growth.

Net income increased to $30.2 million for the quarter or $0.21 per basic and diluted share compared to $19.6 million or $0.17 a year ago. Our net income for the second quarter included a gain of $3.1 million on the sale of four properties. Our strong operating results delivered a 38% increase in AFFO of $59 million for the second quarter compared to $42.8 million a year ago. AFFO per basic and diluted share increased 11% in the quarter to $0.40 from $0.36 a year ago. For the second quarter, we declared a regular quarterly cash dividend of $0.27 per common share to our stockholders on AFFO of $0.40 per share.

Now turning to our guidance for 2016, today we are raising our projected 2016 annual real estate acquisition volume to $1 billion from $900 million, which is net of anticipated sales in the range of $60 million to $80 million. It’s important to note that AFFO per share in any given period is especially sensitive to the timing and volume of real estate acquisitions during the year as well as the spread achieved between the lease rates on new acquisitions and the interest rates on borrowings used to finance those acquisitions. We expect the timing of our acquisitions to be paced throughout the second half of the year, though weighted towards the end of each quarter.

Our AFFO guidance is based on a weighted average cap rate of $7.75 on new acquisitions for the remainder of the year. The timing and mix of debt and equity also have an impact on our AFFO per share in any given period. While we don’t give guidance on capital markets activities, as I mentioned earlier, we are currently targeting a more conservative leverage level that is based on a run rate net debt to EBITDA ratio of 6x, plus or minus 25 basis points or roughly 45% to 47% leverage on the gross costs of our portfolio. Interest costs on new long-term debt for the remainder of 2016 is estimated based on the weighted average interest rate of 5%.

G&A costs are expected to be between $32 million and $34 million for 2016, including commissions and non-cash equity compensation. Based on these assumptions, we are narrowing our 2016 AFFO per share guidance to a range of $1.61 to $1.63 from $1.60 to $1.63. This equates to anticipated net income of $0.73 to $0.74 per share, excluding net gains on the sale of properties, plus $0.78 to $0.79 per share of expected real estate depreciation and amortization, plus approximately $0.10 per share related to non-cash items and real estate transaction costs. As we move through the second half of the year, we will continue to review and update our guidance as appropriate.

And now I will turn the call back to Chris.

Chris Volk

Thank you, Cathy. Before turning the call over to the operator for questions, I wanted to just make a few comments. As you have heard, our second quarter was characterized by sustained strong acquisition activity and investment pipeline, enabling an increase in our 2016 acquisition guidance. Combining this activity with our successful equity raise in May and our deliberate focus on maintaining a more conservative leverage profile and we narrowed our 2016 AFFO per share guidance range.

Turning to the portfolio, we concluded the second quarter with an impressive occupancy rate of 99.8%. Cathy mentioned in her remarks that quarterly rise in property costs, most of which reflect property tax accruals. Such expenses have been a known part of the flow of our business over decades and tend to be lumpy when they occur with generally stable tenant credit and contract risk profiles, which we uniquely report. We don’t see any cyclical economic changes, but simply occasional expected issues that are specific to our individual tenants.

At a higher level, STORE has amongst the highest EBITDA margins of any public and net lease participants. Our G&A costs tend to be higher as a percentage of assets, owning in part to our smaller size. Offsetting a higher G&A costs has been property costs have historically been amongst the lowest of any net lease participant owing to a dedicated approach to investing in triple net lease properties and also to our relative aid as a company with fewer results and vacancies. Looking forward, you can expect our G&A costs to continue to decline as a percentage of assets. At the same time, it’s likely that our property costs will rise over time as the portfolio seasoned. So the net result of G&A efficiencies and anticipated incremental property costs will be that our impressive EBITDA margin is likely to remain fairly consistent.

I would continue to note as I have on prior calls that ours is a great business. Obviously, we have maintained strong EBITDA margins. In addition, our recurring gains from strategic asset sales have been no small profit enabled by our ability to directly originate investments that had yields in excess of those that are available in the auction marketplace. Such gains have exceeded any losses from asset sales, but the surplus gain is positioning us to effectively add to recoveries on any periodic real estate vacancies. We have augmented our strong property management ground game with an equal emphasis on strategic portfolio management.

Now I would like to turn the call – the conversation to corporate governance. Following our recent Board meeting on August 1, we proudly announced the appointment of – to our Board of Mark Sklar. Mark is the well known in the real estate industry and is the founding partner of DMB Associates Inc., which is a multifaceted real estate development and holding company based here in Arizona with operations primarily in four states. His expertise in leading a highly regarded real estate enterprise and his perspective will be valuable to our Board.

And I’m personally proud to announce the appointment of Mary Fedewa to our Board of Directors. Mary is the Co-Founder of STORE and I began to work with her following the 2001 sale of our first public company that we led, which is Franchise Finance Corporation of America to GE Capital where she was employed at the time. Mary’s leadership abilities have been instrumental in making this the best platform we have ever created and she becomes the second insider on our Board of Directors along with myself.

With the appointments of Mark and Mary, we lost the final two Oaktree Capital members our Board of Directors, Raj Shourie and Derek Smith. We are forever grateful for their contribution to our success as we are grateful to the whole Oaktree organization, which is our leading founding institutional shareholder. With this board change, we now stand at 8 directors. You can expect us to be at 9 directors by the end of the year with 7 of those independent.

Two more brief matters. First, we periodically asked about our dividend policy. Over the past 12 months, we increased our quarterly dividend sector – over the past 12 months, we increased our quarterly dividend by a sector leading 8% from $0.25 to $0.27 per share. We have now maintained this dividend level for four quarters. It is our practice with the board to evaluate our dividend policy at each meeting and to consider raising our dividend at least annually as results permit. In this light and in view of the dividend payout ratio that is currently amongst the lowest in the net lease factor, you can anticipate that the dividend move is on the mind of our board as we complete our third quarter.

The last item before turning this call over to questions is to say that with this call, we are nearing the end of our time in our current office space. And actually we all feel highly fortunate to have been located in the same office space since we set about the form STORE in 2011. We have fewer than 70 employees, but have just simply outrun the capacity of our small building. So, we are going to be moving, but not far. Our new office, which we expect to move into in November, will be just around the corner. And interestingly, in an irony that’s not lost in any of us, we will be housing STORE in a portion of the building once occupied by GE Franchise Finance, which was the successor company to our first company that we led Franchise Finance Corporation of America. And just to address any questions about the move, I will note that the event has been long anticipated by us and the modest costs associated with the move are incorporated into our AFFO estimate range.

To conclude my commentary, we continue to be off to a good start for 2016, are optimistic about our 2016 prospects and our future growth. And with this, I will turn the conference call over to the operator for any questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And our first question will come from Paul Adornato of BMO Capital Markets. Please go ahead.

Paul Adornato

Thanks. Chris, every once in a while, it’s good to get your take on what we should expect in terms of size of the enterprise, obviously competing goals in terms of liquidity, acquisitions, growth rate. So, I was wondering if you could just give us a little bit of a preview of what we should expect as you move into larger quarters?

Chris Volk

So, why don’t you clarify the question or flush that question out?

Paul Adornato

How big do you – should we expect the enterprise to be? Obviously, as companies get bigger, it takes more acquisitions to maintain the same growth rate and so you have added the staff, but was wondering how rapidly we should expect enterprise growth?

Chris Volk

Sure. So, first is if you – and this will happen with any real estate investment trust or any company as you get larger and larger, then you start having a denominator effect, which means that your growth can potentially slow. It is likely to slow down just because you are running so much bigger enterprise. So, in order to offset that, it’s important to create a company that has good bones, good structure. And the way you do that, first of all, is to try to max out the internal growth that you can do, so the growth that you can realize without going out for raising new equity. And REITs only really have two ways of doing that and the structure what the other companies do, but REITs have two ways of doing that. One is to have a low dividend payout ratio where they can reinvest and roll cash into new assets and the second is to do the best they can to have high lease escalators in their properties. So, in both cases, if you look at the net lease space, we have either the lowest or amongst the lowest dividend payout ratios than we have amongst the highest or amongst the highest rent increases. So, we have intentionally positioned this company to be able to have internal growth. And I would point out that both those numbers well exceed any prior companies that we have run. So, the two prior platforms that we have ran on the New York Stock Exchange didn’t have the same kind of payout ratios or the same kind of escalators that we currently have today. So, it’s been very intentional on our part.

So, then the second thing is to what extent can we grow on a relative basis externally the same way? And of course, our guidance for the year is $1 billion net of sales, which is actually less than the activity that we did in 2015. And it’s – and we do that guidance intentionally, because we are in the flow business. You saw from this quarter, our average transaction size was about $9 million. We did 37 transactions – separate transactions, so the amount of deal flow we are seeing is also on the high side of what anybody else would do. So, we were definitely sort of a granular flow type shot. So, it’s not easy for us to sort of see out for the rest of the year and say we are going to do $1.2 billion worth of business. That being said, if it’s up to Mary and her team, we are going to do our level best to do it if we can find the transactions we want to do at the kind of lease rates that we have been generating, at the kind of debt we can borrow at and the kind of equity costs we have been afforded the amount of accretion to shareholders from growth is really impressive if we can do it and keep doing it smartly. So, now the thing that stands in the way of us doing more volume is, in our view, just more relationship managers. So, the market is so large and the market is so underserved. And you think about the number of institutional players that collectively have less than 10% market share of this market in terms of deals that are done every year. And of course, we are not here just to steal market share from other players. We would like to create demand. So, the question is how much bigger can you make the market? And I think that going forward, there is a – there are opportunities for us to add to our origination staff and to steadily address the market in a more complete fashion, which should hold off the denominator effect for a while. It won’t hold off forever, but it will hold off for a while. So, that’s the thought process.

Paul Adornato

Great, thanks. And just one follow-up, dispositions this year, what are they and maybe you can provide a little bit more color on those?

Cathy Long

We sold four properties during second quarter and they were – and there was a gym and three restaurants.

Chris Volk

Yes. So, we estimated that we would be doing $60 million to $80 million worth of sales at the beginning of the year in guidance. We are not changing that guidance number. It’s possible changes, but we will reassess that later on. I think it’s important for us to sell properties on an annual basis and you see sale activity with companies other than ourselves, too. And the sales come in sort of three groups. The first group of sales will be assets that we have concerns about. And so basically you are talking about portfolio culling where we are trying to avoid potential problems. And the second type of sale will be opportunistic sales in that group. And the opportunistic sales will oftentimes come from the sale of assets with tenants who are not likely to grow our relationship with substantially, but are very nice. Companies – and there you can sort of opportunistically look to book some gains and then the gains are fine as long as you can reinvest the proceeds at a higher lease rate, so it’s accretive to AFFO per share. And then the third type of property that we will occasionally sell is just where you got the reverse inquiries. And anybody who is going to be in this business from time to time will get calls from brokers and investors looking to buy a specific piece of property that people know that we own and occasionally we are beginning to do that. So, between all that, we are at $68 million for the quarter – for the year rather and we think that, that’s achievable.

Paul Adornato

And these quarters, which buckets do they fit into?

Chris Volk

It’s kind of like half and half. I would say the four properties, two of them were strategic and two of them were portfolio management.

Paul Adornato

Got it. Okay, thank you.

Chris Volk

Sure.

Operator

Our next question will come from Vikram Malhotra of Morgan Stanley. Please go ahead.

Vikram Malhotra

Thank you. Just wanted to get some more color on a new top tenant that you have in the early child education space, I think you bought a bunch of stores?

Chris Volk

Sure. Well, the name of the company is Cadence Education. And Cadence has actually been a long time customer of ours, so it’s not new, just new to the top 10 and it’s a consolidator of early childhood education facilities. It’s been owned by a private capital for quite sometime. Today, it’s the sixth largest childcare operator in the U.S. with somewhere in the neighborhood of 175 locations, which are operated under multiple brand names, so they don’t – they would not take any approach where they take one brand name and make it universal. I tend to like that personally because it means that you have implicit in the investment, you have more diversity for the brand names in different marketplaces. So it’s having one brand name that could have issues across the country. You have lots of different brands that are local to communities they serve in different types of schools. So – and we like the early child education business. It’s a service business and we tend to like service enterprises because you can’t educate your children or take care of them over the Internet, so as much as we might like to try.

Vikram Malhotra

And rent bumps and the lease length are similar to sort of what you have done more recently in other deals?

Chris Volk

Yes. I mean it’s master lease assets and similar rent box, yes.

Vikram Malhotra

Okay. Just on the watch list, if you can just give us any color on Gander, that’s obviously been a topic for you guys and maybe some of your peers. And then just related to that, I wanted to check if you had any exposure to Ruby Tuesday, I believe in Illinois, they did have some challenges and had to shut a bunch of stores?

Chris Volk

Sure. So in the case of Gander Mountain, the news that we are getting from the company is that they are well ahead of where they were at this point in time last year and – now keep in mind that just like any other retailer, the second half of the year is important. So – but obviously, we feel good about what they are doing. And as we have said before, we get level of financial statements on the properties that we have and we feel good about the properties that we own. As far as Ruby Tuesdays are concerned, we do have some exposure to the Ruby Tuesdays in Illinois, you mentioned. There are actually seven stores in that group. We acquired those properties out of bankruptcy, so the Ruby Tuesday’s operator actually filed for bankruptcy once before. Our average investment, I don’t know it’s something like $1.2 million a piece. So – and I would tell you that land alone just can be in the high six-figure numbers. So I mean it could be even low seven-figure number. So we feel good about those if we have to rent them and we have interest in that and people – from people wanting have a property. So we don’t think that’s going to be any problem for us.

Vikram Malhotra

So just to clarify, are all seven stores, are they coming back to you, are you selling some or just – can you give us some color on that?

Chris Volk

We anticipate that the seven stores will come to us and included in the property taxes that Cathy gave you for the quarter were property taxes pertaining to the seven stores.

Vikram Malhotra

Okay. So a potential downtime and other tax operating costs are in guidance as well?

Chris Volk

Right. And I mean just as a percentage of revenue, that’s two-tenths of 1% expense.

Vikram Malhotra

Yes, that’s fair. Okay. Thank you.

Operator

Our next question will come from Dan Donlan of Ladenburg Thalmann. Please go ahead.

Dan Donlan

Yes. Just going back to Vic’s question Chris, it’s two-tenths percent, it’s very meaningless, but is there anybody else that is worried about that something similar could happen, too?

Chris Volk

The answer is that we always have people that we are thinking about. I mean if we didn’t have people we would be doing sort of like the guy who is lending money and has no loan losses. I mean if you are in the business that we are in, you expect to have some vacancies from time-to-time and we bake those into our AFFO projections every year, not knowing exactly which tenant might go vacant on us from time-to-time, but you assume that there is going to be some vacancies from time-to-time. And that’s just part of the business and part of the financial model that we have. So I can’t point to anybody right off hand and say I am going to get something back. There is no sort of imminent view that I have on anything like that, no.

Dan Donlan

Okay. But would you start to see it though if the economy starts to slowdown, I mean would you start to see it in kind of your tenant base, I mean…?

Chris Volk

Yes. So like if you look at our – so we are the only guys that even give you a tenant histogram or a contract histogram. So if you look at our tenant and contract histograms, the difference in default probability between this quarter and last quarter is like three-tenths of 1% or so. I mean, it’s 3 basis points, it’s three-one hundredths of 1%. So, it’s virtually flat. And I would say that looking at that gives you a pretty good indicator of where that market is. I mean what we are seeing is that some of our tenants are doing better, some of them are doing worse. On the average, it’s kind of the same. The coverage is they all tend to be about the same. And corporate credit profiles tend to be about the same. And I don’t think that we are in a growth economy. I think our economy is fragile to be candid with you. So I think that we are positioned. If there is a downturn, we are positioned because we have – our median coverage is high enough so that we have lots of room for error and that’s what you want to do. So if you have margin for error – I mean you want to be in a position where you can have tenants that actually become insolvent and you still get paid the rent. I mean that’s the business that we are in. So we are designing and have always designed our companies to be defensive even though they are growth companies.

Dan Donlan

Okay. And just going back to Vic’s question on the early childhood education centers, you are up 7.6% from 6.4% last quarter with the cadence moving up the chart here, the table here, just kind of curious of your thought process on that overall industry, I think we saw a big move in day care centers a couple of decades ago and there seems to be a lot of activity in this early childhood education space, there are some other REITs that are obviously doing projects, we have heard some guys have been expanding fairly rapidly, we are just kind of curious like how the coverages have trended since you got kind of into this space and kind of your overall viewpoint of the space?

Chris Volk

Well, our coverage isn’t – daycare has been flat, so they have been increasing dramatically. We have seen a lot of private capital, private equity interest in the space. So if you look at the larger participants, it’s – there is a domination in the space by private equity capital, which tells you that there is a lot of interest in early childhood education and certainly comp. Politically, there is a lot of interest and discussion about diverting capital to increase private education. So I think that’s a good thing. At the same time, we are very mindful of making sure that most of the money that we are getting on early childhood education comes from private play. So we are – so that’s basically been our dominant focus. And we like the space. We think it’s essential space and I would tell you, the other thing that we have liked about it is that on average we have probably invested – I am going to say that were sub-80% on – in terms of where our investments are relative to replacement costs. And so we are – if you are in these assets and expensively enough then it creates also barriers to entry in terms of people building new assets. They compete with the assets that you have. So – and we are dominated by master leases in the portfolio and by large operators. So I think all of the things stick in favor of the strategy.

Operator

And our next question will come from Craig Mailman of KeyBanc Capital Markets. Please go ahead.

Craig Mailman

Hi guys. So maybe just a little bit more color on the decision to kind of bring the long-term growth rate down to kind of 6% – or 6x at the midpoint versus the 6.5x, was that solely just because that’s where the rating agencies wanted you to be to get the pricing in the unsecured market?

Chris Volk

I think in a nutshell, that would work. I think that will be an accurate assessment. I mean if you wanted to – I mean our game here is not to be a BBB- company. So our game here really is to be a BBB flat or better company than that. So and to be in that sort of ballpark being a large profile that’s closer to 6 is something that the rating agencies would think to be important.

Craig Mailman

What do you guys think the benefit from pricing would be for that move kind of – because you are giving up obviously the growth rate that you can enjoy with higher leverage, is it enough to warrant the lower leverage longer term?

Chris Volk

In my view, it probably is, because you are – I mean and it’s several things that go into it. I mean first is that just from a pure math perspective, there tends to be sort of a chasm between BBB rated debt and BBB- debt. So, BBB- debt is one notch from junk and I think that investors have a tendency to note that. The second thing is that BBB debt enables people to go into preferred stocks. And if you look at the rate differential between a BB rated preferred and BBB- rated preferred, again, the drop-off is pretty material. So, you get the benefit from all that. Then the question is – then your other question is well, great, but maybe it’s worth paying the higher price and the higher freight to generate a little bit more growth. And even there, I would say to you that the general observation that we have had is that REITs tend to get rewarded for having sort of conservative leverage profiles. And if you look at our recent Greenstreet report on REITs and leverage, it will basically underscore the notion that our REITs having lower leverage tend to be at quarter higher multiples. So in that sense I think that also benefits shareholders.

Craig Mailman

You mentioned preferred stock, if I recall right, you haven’t been the biggest fan of them. Is this shifting that thought process at all?

Chris Volk

I am not personally the biggest fan of them only because there has never been a time in my life where I couldn’t have borrowed money on master funding conduit or certainly a BBB rate that kind of a cheaper prices. So, if you take the actually cheapest rate, the preferred stock has ever gotten, by and large, we have tended to be able to come in at lower rates even at sort of – most any market. So, that is true. On the other hand, I tend to be a believer that long-term rates are going to stay in a very low bandwidth for a while, and I am not happy to say that. I wish where actually rates would go up. I don’t think it’s healthy for the economy to have a 1.5% 10-year treasury, but if rates stay low for a protracted period of time, then it’s possible that there maybe some opportunities for preferred stock in terms of yield seekers looking to buy and we have certainly had lots of people approach us in that regard. And I think in terms of our ability to be opportunistic, it would be enhanced if we were BBB flat company.

Craig Mailman

That’s helpful. And then just one more on leverage here, you talked about having one of the lowest AFFO payout ratios from a dividend perspective. I mean, how does the dividend policy change going to lower leverage? Are you guys going to target more of taxable net income rather than AFFO payout to maybe offset some of that growth headwind by using retained earnings to put to work?

Chris Volk

Well, the answer is you always – we have been able to do it today than we are able to do last year was to raise our dividend 8%, but raise it at a rate that was actually less scenario full growth per share. So, our payout ratio, year later, is actually lower than it was last year. If we could do that for a bit, if it was possible to do that, that will be a huge thing. If we could grow our dividend at a slightly slower rate than we are growing our FFO per share, then our payout ratio declines permanently. And what happens when you get the denominator effect in these companies is that it then gets to be extremely difficult to lower your payout ratio. So, if you are a very large company and you have a payout ratio of 80% some odd, getting down to sub-70% is extremely difficult. So, the best way to start that is to start early. And so that’s what we are trying to do here. And I would say that the payout ratio is a constant. That’s a little bit independent from just debt, although when you are – if you think about how REITs match fund themselves, I mean, you can’t match fund a lease. I mean, I don’t care whether you are doing office buildings or multifamily or shopping centers or net lease companies, you can’t match fund leases. So, what you have to do is match fund cash flows. And so you think you have a lot of free cash flow after dividends, then you are able to use that free cash flow essentially as a proxy for debt maturities that come due every – that year. And to the extent your free cash flow is equal to your debt maturities, your asset liability neutral to the extent your liabilities coming due or more, you are slightly liability sensitive. So, you want to sort of limit your liability sensitivity to an amount that’s pretty modest relative to the balance sheet and having a low payout ratio also helps you do that.

Craig Mailman

Helpful. And then just one quick one, on the acquisition side, do you guys have been doing $100 million a month. I mean, is there any big large portfolios out there that you would be interested in?

Chris Volk

We evaluate large portfolios from time-to-time as they come to the market, so we see some large portfolios. And occasionally there is some footing out there, as you probably know by now, STORE tend to not to win any of those deals. We are also pretty much big sticklers for maintaining high levels of portfolio diversity, which is going to limit the amount of participation we could do in any large transaction anyway. We have done this year, so we did over $100 million a month. So, you are talking – we have done over $700 million through this phone call today. And of that $700 million, $100 million of it is fleet. So, that’s not a portfolio deal, but I would say that’s unusual for us, I mean to have a transaction of that size they don’t have in one quarter, we are having in two quarters.

Craig Mailman

Okay, thank you.

Operator

Our next question will come from Ki Bin Kim of SunTrust. Please go ahead.

Ki Bin Kim

Thank you. How much of your debt, especially your master funded debt is pre-payable without penalty?

Chris Volk

None of it.

Ki Bin Kim

Okay. And in terms of your fitness tenants, what are the brands and how are the coverage ratios trending so far in that segment?

Chris Volk

The coverage ratios tend to be on par with the overall median portfolio coverage. And from a brand perspective, we tend to focus on super regional players, so they wouldn’t be players that would roll off the tip of your tongue. So, we are not doing all the fitness, our lifetime fitness and we have done some goals, but they have been franchisees, but they have been here locally in town. There is a company called Mountainside Fitness, which is one of the largest fitness operators in Arizona and they are a customer of ours and there are companies like that elsewhere.

Ki Bin Kim

And has the coverage ratios been stable over time?

Chris Volk

Yes, they have been.

Ki Bin Kim

Okay. And just sort of a broader question on your restaurant portfolio, any noticeable change in how your tenants have performed over the past few months? There has been some data out there showing a slowdown in casual dining lately. So, I was wondering if you are seeing more of that besides this Ruby Tuesday in your portfolio?

Chris Volk

No, we saw some of the data and we kind of compared it to our portfolio and we haven’t seen anything that’s hit the portfolio. The Ruby Tuesday thing is, I mean, he was doing fine in business last year. His sales dropped over 20% and which is not – has nothing to do with casual dining. It has everything to do with perhaps him, but also the brand, I think has suffered substantially. So – but outside of that, outside of specific examples like that, we are not seeing any sort of material reduction in revenues. We are seeing also some reduction in costs. So, obviously, some of the food costs, some of the commodity costs that have been in the restaurant space have actually come in. So, some of our concepts will have slightly lower sales, but actually the coverages are about the same.

Ki Bin Kim

Okay. So, it has kind of followed the general industry trends, but nothing outlying – no outliers?

Chris Volk

No.

Ki Bin Kim

Okay. Alright, thank you guys.

Operator

Our next question will come from Tyler Grant of Green Street Advisors. Please go ahead.

Tyler Grant

Good morning. I just wanted to follow-up on the Cadence transaction as well. Just really kind of – what does the real estate look like and what are residual value prospects on the real estate in the case that you have one day down the road may need to re-tenant it?

Chris Volk

Well, I look at the early childhood education space as it can – in some respects, the restaurant space. So, for example, if you take a restaurant back, they make a product. And so if you take – if you get RBs back and you – it’s empty, you can put a chipotle restaurant in it, you can’t do this by the way with convenient stores. I mean, nobody tries the new guest, right? I mean, nobody cares at all about new guest. But in the restaurant space, you can definitely reflag something and people come there, because they make a different product. Early childhood education is much the same way. I mean, there are different approaches to how people educate children. It is very much a ground game in terms of who is running the facility, what kind of relationships they have with the marketplace. So, your likelihood that a property that will be vacant in early childhood education would stay in early childhood education is hyper high. If it’s not early childhood education, then you are looking at things like physician offices, veterinary clinics, things like that, which we also do from time-to-time. And they are – they have – your typical early childhood education has very strong residential backup to it. It is not a – it’s not a retail establishment like you would think of, but it would be oftentimes something that could be done from a service basis that addresses the community at large. And a lot of times, because they are in residential areas, it’s hard to get zoning for business assets like that. So it creates a limitation of supply. So we feel pretty good about the residual value of these assets.

Tyler Grant

Okay. And then just in terms of – if you have to breakdown the amount that you paid for the assets and attribute it to what you are paying for the lease contract versus what you are paying for the real estate, what would that breakdown look like on a percentage basis?

Chris Volk

Well, this is the beauty of this. So we actually – if you want to know what we pay for lease contract, Mary’s people make a certain commission. We are paying nobody for the lease contract and we are buying the assets for below the cost to reproduce. So our average investment in early childhood education stands at around $3.8 million today. And we are in less than what it cost to make and we are ascribing no value to sort of creating the lease because we are not buying these things over to a lease. So there is no lease intangible.

Tyler Grant

Okay. So I mean aren’t you paying some kind of premium to where the real estate vacant would trade when you purchase the assets from the tenant while doing the sale leaseback?

Chris Volk

Okay. Well, so now you are getting into a different question, alright. So the question is can a net lease company in general buy assets of dark value, I mean that’s really the question you are asking, right.

Tyler Grant

Yes.

Chris Volk

And the answer is there is no net lease company ever invented they can buy assets at just dark value. I mean – and by the way, dark value is in the eyes of the beholder. So some person might be looking at it saying, gee it’s going to be a check cashing center or something like that, something at the low-end of the totem poll. Somebody is going to look at it and say well, it will be a fine casual dining restaurant. So what dark value is, is really almost and indeterminable number. But I can tell you if we or anybody else in the net lease space spend our life limiting our investment to dark value, then we will do no business. So you are – we are in the business of taking risk and embedded in our AFFO projections every year are expected losses on – and expected vacancies that occur. And offsetting those expected vacancies and losses are sometimes gains from sales of assets. So you have a property management issue at the ground level and then you have a portfolio management issue at the high level. And the question is can you make a very nice rate of return for shareholders even though you can’t buy assets with dark value and the answer is yes and we have been proving that for 30 years.

Tyler Grant

Okay, that’s helpful. And then just moving on to another question, are you seeing any interesting trends in the net lease transaction markets in terms of changing market participants or cap rates or anything along those lines?

Mary Fedewa

Hey Tyler, it’s Mary. So I know I would say that – hi, I would say that the market is really – it’s big, it’s large, probably [ph] 70,000 middle-market and larger companies that we focus on. So we are not – we are seeing a lot of opportunities without knocking on a lot of doors of companies that own their real estate. And we haven’t – so there is plenty of room for other folks to come in, but we haven’t really seen any significant change in any – in the competitive landscape at all. And cap rates are really stable.

Chris Volk

And I would say maybe even the last 5 years, 6 years, 7 years we have seen a decline in participants, right. So, you have seen people like Cole Capital who used to be big, no longer is big. ARCP on the private capital side, no longer there, all of REITs there, but GE franchise who we sold our company to GE bought, not only FFCA, they bought MetLife Capital, they bought Trustree, Trustree bought U.S. restaurant properties. GE bought Merrill Lynch Capital. GE bought Citigroup franchise Capital, Howard financial, all that stuff is basically out of the market today. And so we are placing that has – of course, STORE is kind of a new entrant although we are sort of part of the same group that’s been there for long time. I would say – and then finally, you have got things like Dodd-Frank, which didn’t exist and Dodd Frank actually works to make the net lease market just a much more desirable market because we cannot only lower people’s cost of capital level relative to traditional banking choices, but we can actually give them more balance sheet flexibility, which is part and parcel of – all these things are part and parcel of the difficulties of Dodd Frank is in probably in both the Basel III on the commercial banking space. So to Mary’s point, I think that we have – it’s a $2.5 trillion marketplace and we are not really scratching the surface of it.

Tyler Grant

Okay, very interesting. That’s all for me today. Thank you.

Mary Fedewa

Thank you, Tyler.

Operator

Our next question will come from Todd Stender of Wells Fargo. Please go ahead.

Todd Stender

Hi. Thanks. And I am sorry if I missed this, but you guys added to your industrial portfolio, can you speak about the properties you acquired and any pricing and lease term information you can give?

Chris Volk

I would say first of all, if you look at the five new industries that we are in, almost all of that tends to be industrial, so it’s just one off-site because we are basically using – we are using FIC codes or whatever to come up with, we are getting pretty precise of what the businesses are and…

Cathy Long

And the industrial stuff tends to be pretty unique in terms of the type of things they do like they might make medical products or they might make string guitars and so all of those are new industries, if you will. And so that’s where all the new industries came from and it continues to be really diverse and adds to the diversity of the portfolio actually and it was just a handful.

Chris Volk

I mean it’s all manufacturing, Todd. So it’s not – we tend to a stay away from distribution stuff. So the point is we want to be in assets that make a product. I mean they have to have a P&L, a unit P&L. This is where we get 97% of our properties or have reporting requirements. If it’s something that’s a distribution facility like a FeDex distribution facility, for example, it’s really overhead the cost center, our profit center even though you are reckoning on industrial asset. So when we are thinking about industrial, it tends to be manufacturing.

Cathy Long

And structured Todd, is the same long-term leases, master leases and cap rates are very consistent with the portfolio.

Todd Stender

So lease terms will be in a retail range, would it be 10 years plus?

Cathy Long

15 years. Yes.

Todd Stender

And cap rates, where would they kind of range?

Chris Volk

I would say that they wouldn’t be far off from the average range that we report for the quarter.

Todd Stender

Okay, great. Thank you.

Cathy Long

You’re welcome.

Operator

Our next question will come from Chris Lucas of Capital One Securities. Please go ahead.

Chris Lucas

Hi everybody. Hopefully this will be quick, just a couple of detailed questions, one on the dispositions for the quarter, can you give us the dollar volume and the cap rate on dispositions during the second quarter?

Cathy Long

Second quarter was $16 million. Year-to-date is $17 million. That was the original cost of the properties and cap rate was 7.5.

Chris Volk

Cap rate was 7.5 and which is basically the assets we are generating returns of about 8.6x. And that’s a mix of some of the – I mean there are five – four properties here, so some of them were sold in the 6s and some of them were sold higher so...

Chris Lucas

Okay. And then as it relates to just the use of capital and capital allocation, the dividend policy, what – how much free cash flow do you guys generate right now on an annualized basis roughly?

Chris Volk

We don’t have this number on top of our head. So we have the brain trust calculating it for you. So while they are calculating it for you, do you have any other questions?

Chris Lucas

Yes. Last question for me Chris, just on and maybe Cadence transaction is helpful in understanding, but when you buy these assets, are you buying sort of legacy assets that they have had under management for a long period of time or are you buying assets that they are acquiring as part of the overall consolidation plan?

Chris Volk

The answer is when we started doing business with them, we acquired some legacy assets. More recently, what’s catapulted them into the top ten is they have made a number of acquisitions that have been from Massachusetts to the Midwest, so from East Coast to Midwest. And those acquisitions are also established, long-standing companies, facilities and so we did those acquisitions, we helped them do those acquisitions and we would have to close the table with them.

Cathy Long

And they acquired Chris, companies that have been are existing, kids come with them in the whole nine yards.

Chris Lucas

So how much of a history are you looking for when you are looking at those kinds of assets?

Chris Volk

You are going to get – sometimes, you will get 5 years, 10 years of history. You get a lot of history.

Chris Lucas

Okay. That’s all I have but I would like to retain cash flow number if you guys have it.

Chris Volk

We are rolling through that. So we will do that before this call is out.

Chris Lucas

Great. Thank you.

Chris Volk

Thank you.

Operator

Our next question will come from Collin Mings of Raymond James. Please go ahead.

Collin Mings

Hey, good morning.

Chris Volk

Hi Collin.

Collin Mings

I guess two questions for me, just really going maybe the flip side of the watch list question Chris, just any sectors or tenants where you are more optimistic than a year ago to just review unit level financials, anything that’s kind of improving, if you will on the histogram?

Chris Volk

I would say, no. I mean we are not seeing anything that’s – we are not seeing anything where we are looking at something and saying this is an industry we have to be in. We want to do more of it. And keep in mind, like we tend to be – it’s sort of like the restaurants. If you think about the restaurant space, I am not in love with any restaurant brands, but I am in love with them at the right price. So for the right price, as long as the coverage is there, we like it. Most – everything that we do is legacy assets. We are buying existing assets that have a track record. And so we can buy the assets at a decent price and the track record is stable, we tend to like it. If you buy – if you are into the growth industry, which you can have growth industries if you are into a growth industry, but you are paying a lot for the asset, then I can’t get that excited about it. So we have always tended to stay away from growth restaurant chains and things that – if the stock market likes it, we may not like it. I mean it’s an interesting thing like there could be a natural opposite affect because the stock market tends to like growth and we – we are looking for stability and it’s a different issue. So – and growth always comes with the tenant risk. So when people are swinging money and building lots of stores really fast, that’s the kind of stuff we tend to watch out for.

Collin Mings

Okay. And then maybe just kind of going back to Ruby Tuesday, just kind of understanding kind of what was maybe underwritten or expected there again recognizing it’s a very, very small part of rent, just maybe where would that have fallen on kind of the histogram of probability to call it a year ago?

Chris Volk

The coverage on those properties wasn’t really huge. So the coverage on those properties a year ago might have been somewhere around 1.20 or 1.25. They weren’t really great. But we were okay with it because we thought there was some upside to it and we also – we are in the assets so incredibly inexpensively. I mean our investment in these assets just you put it, typically to build a casual dining asset is going to cost you $2.2 million just for laying a building typically. We are in it for $1.2 million. And we also have leans in all the FF&E. So we have got all the equipment, all the seating, everything. So the downside was so limited for us that we did the transaction. And I mean at the time we did the deal, I think our cap rate was like a 10 – it was double digits because we bought it out of bankruptcy, but there was no amount of rent that we could lower it reasonably to sort of make it work. I mean, so – I mean and it’s unfortunate fact that this not only have brands that just fail, just cease to work. It’s actually interesting in Illinois at one point a few years ago you had the largest Applebee’s operator, the big Applebee’s operator in Illinois shut their stores. It’s very possible that some of these end up getting re-branded to Applebee’s today who knows, so...

Collin Mings

I mean maybe just thinking about kind of what you have referenced as far as the coverage there, so it’s definitely been at a year ago call, the lower end of your store score ratings, but if you think about the residual real estate guidance, still something where you had comfort in the investment?

Chris Volk

Right. So when you are looking at the store score ratings, one of the things we always tell people is its not qualitative. It’s just really quantitative. I mean you are looking at. I mean, it’s just a function of an algorithmic expected the fall frequency generated by Moody’s and multiplied by a – multiply that by a probability that the stores would be lost 2and they have had a bankruptcy that we come up with a pretty simple algorithm for that. So you have no notion of, for example like you can have a company that’s got a huge senior debt capital stack or a big mezzanine capital piece of the stack. That to us is sort of like equity. Asset based lines of credit are not like equity, they are definitely very senior lenders. So capital stacks play a role to it. The price that we are in the properties plays a role. So in this case, it’s – we are in the properties for 0.2% of our whole portfolio and we are going to probably do very well in these properties because we are in so inexpensively.

Operator

And ladies and gentlemen, as we are out of time for questions, this will conclude our question-and-answer session. I would like to turn the conference back over to Chris Volk for any closing remarks.

Chris Volk

Alright. So Vikram, this is for you.

Cathy Long

Chris Lucas.

Chris Volk

It’s Chris Lucas, I’m sorry. So if you look at our AFFO per share, it’s around – annualized around $215 million in dividends, is that right.

Cathy Long

Cash flow before dividends.

Chris Volk

Cash flow before dividends, so it’s basically from the statement of cash flow. $166 million in dividends gives you $50 million of surplus cash. And obviously, that is going to increase over time as we grow. So we don’t have any debt maturities for the next 3 years really of any small amount. So then it gets bigger. And so when our debt maturity starts kicking in, the average debt maturity is around $200 million to $250 million. By the time that happens, our guess is that the free cash flow obviously is a much bigger number and so you end up having much less liability sensitivity. And the liability sensitivity you do have is very small relative to the balance sheet that you have at the time. So and I should also say that our early debt maturities that do come due in the next few years will be – they are somewhere around 6%, so it’s a higher price debt.

With that, we are pleased to give you our report for the quarter and look forward to seeing you all sometime in the future. And thank you very much. Bye.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect your lines.

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