Spirit Realty Capital (NYSE:SRC)
Q4 2016 Earnings Conference Call
February 23, 2017 11:00 AM ET
Pierre Revol - VP, IR
Tom Nolan - Chairman and CEO
Jackson Hsieh - President and COO
Phil Joseph - CFO
Boyd Messmann - Chief Acquisitions Officer
Anthony Paolone - JPMorgan
Alexander Goldfarb - Sandler O’Neill
David Corak - FBR Capital Markets
Haendel St. Juste - Mizuho
Daniel Donlan - Ladenburg Thalmann
Michael Knott - Green Street Advisors
Landon Park - Morgan Stanley
Ki Bin Kim - SunTrust
Joshua Dennerlein - Bank of America Merrill Lynch
Robert Stevenson - Janney Montgomery Scott
Good morning ladies and gentlemen, and welcome to Spirit Realty Capital's 2016 Fourth Quarter and Full Year Earnings Call. As a reminder this conference call is being recorded. I would like to turn the call over to your host for today’s conference Mr. Pierre Revol, Vice President Investor Relations. Sir you may begin.
Thank you, Operator. Good morning and thank you everyone for joining us today. Presenting on today’s call is Tom Nolan, Chairman and Chief Executive Officer; Jackson Hsieh, President and Chief Operating Officer; and Phil Joseph, Chief Financial Officer.
Before we get started I would like to remind everyone that this presentation contains forward-looking statements. Although we believe these forward-looking statements are based upon reasonable assumptions, they are subject to known and unknown risk and uncertainties that being cause actual results to different materially from those currently anticipated due to a number of actors. I refer you to the Safe Harbor Statement in today’s earnings release and supplemental information as well as our most recent filings with the SEC for a detailed discussion with the risk factors related to these forward-looking statements.
This presentation also contains certain non-GAAP financial measures. Reconsolidations of non-GAAP financial measures to the most directly comparable GAAP measures are included in today’s earnings release and supplemental information, filed with the SEC under Form 8-K. Both today’s earnings release and supplemental information are also available on the Investor Relation section of our website.
For our prepared remarks, I’m pleased to introduce Tom Nolan.
Thank you, Pierre. Good morning and thanks everyone for joining our year-end 2016 earnings call. This morning, I will start with an overview of our 2016 accomplishments, Jackson will provide more details on our portfolio acquisition and dispositions and finally Phil will provide more details on our financial results. We will then take your questions.
2016 was a typical year for Spirit. We made major strides toward our ambition of being recognized as they best-in-class suite through active portfolio diversification, material balance sheet improvement and building the right executive team that will create long-term value for our shareholders.
During the fourth quarter, we continued to focus on improving the quality of the assets in our portfolio including the sale of the 84 Lumber portfolio and five Shopkos. We maintained our balance sheet leverage at 6.2 times debt-to-EBITDA, a material improvement from the same period last year.
We believe that smart acquisitions and continual portfolio management are key drivers to attractive long-term returns in the triple net lease sector. Over the past year, we acquired approximately 705 million of high quality assets while selling 585 million of properties that were either accretive on a risk adjusted basis to reinvestment opportunities or no longer core to our strategy. Our sales included 108 properties leased to 84 Lumber as well as the monetization of certain of our Haggen and ShopKo locations.
During the year, we sold two of our former occupied Haggens for a 4.5% weighted average cap rate, which was 300 basis points lower than our acquisition cap rate. We lowered our ShopKo concentrations to 8.2% of normalized rental revenue and our top five and top 10 tenants now comprise 17.5% and 25.8% of our normalized rental revenue respectively, down from 19.4% and 26.5% respectively one year ago. These diversification improvements now position us as having one of the most diverse portfolios among our peer set.
In 2016, we grew revenue by 3% to $686 million and AFFO by 9% to $413 million. AFFO per share grew by a modest 1% as we did make the decision to forgo a higher potential near term earnings growth rate in exchange for strengthening the balance sheet and as such position the company for stronger growth in the years to come. This was principally accomplished through our $370 million equity capital raise in April.
Furthermore, having extinguished approximately $833 million of higher coupon debt, as part of our liability management program and achieving three investment grade ratings, we accessed a new capital source with the completion of our de novo $300 million unsecured bond issuance in August. As a result of this work, we reduced our cost of capital and ended the year at 6.2 times debt-to-adjusted EBITDA versus 6.9 times at the beginning of the year.
Finally, we strengthened and deepened our management team, providing leadership that will drive our next phase of growth. As we have stated in the past, we are committed to hiring best-in-class executives and team members in order to position Spirit as a leader in the net lease sector. Our move to Dallas is complete and with our experience bench we are benefitting from the innovative and forward thinking approach to our business.
As you heard last quarter, Jackson spearheaded an effort to take a fresh look at each of our assets, which we are now utilizing to optimize our capital allocation and identify potential opportunities within the portfolio. We will continue to be prudent in our approach to acquisitions and incorporate these insights into future acquisition or dispositions. We continue to see opportunities to accretively recycle assets and given our enhanced process in methodology, we believe we can further improve the portfolio and deliver stronger growth.
Regarding our financial position we entered 2017 with a solid and flexible balance sheet. We have very manageable debt maturities through 2018 and we expect to continue to unencumber assets while keeping our leverage at levels consistent with our stated targets. Phil will provide further comments during his remarks.
Additionally, as part of our commitment to provide both long-term growth and an income for our shareholders, I am pleased to report that we raised our dividend for the fourth year in a row to $0.18 per share, which represents a 2.9% increase over the prior year. Furthermore, let me note than in 2017, we plan to be even more proactive with meeting and speaking with the investment community, while continuing to provide transparency into our business.
We always welcome investors to visit us in Dallas and we are looking forward to our May 17, Investor Day in New York. We plan to provide more details on our strategy as well as new disclosures around our process and portfolio that we think our investors will appreciate.
Finally, I started my remarks with a reference towards our ambition of establishing ourselves as a best-in-class REIT. As I have noted, I think the company made substantial progress in 2016, particularly as it relates to our portfolio, balance sheet and people.
There is one other area, I would like to touch on and this is governance. Just like other elements of our business, we want best practices that are part and parcel of being the best-in-class REIT. As such, after a thoughtful and thorough review of our governance provisions, I am announcing that prior to our annual meeting in May, the company intends to permanently opt out of the so call mute [ph] provision that would allow us to stagger our board.
With that I'll turn it over to Jackson.
Thanks Tom and good morning everyone. I'll begin with an overview of our portfolio's operating results and then discuss our acquisitions and dispositions within the quarter and provide additional color on our portfolio and capital allocation.
As of December 31, our portfolio was 98.2% occupied and had an average remaining lease term of 10.7 years. 45% of our normalized rental revenues were derived from master leases and 89% of our leases have built in rent increases. Our unit level rent coverage remains healthy at 3.0 times on reporting terms.
During the fourth quarter we were net disposers of assets acquiring $248 million and selling approximately $272 million of assets. We acquired 42 properties comprised of 23 tenants at a weighted average cap rate of 7.3% which was a mix of existing and new customers. We purchased a Mr. Carwash in Saint Paul, Minnesota from an existing tenant which strengthened our master lease and furthered our relationship with them.
We have added a new customer with Sunny's Barbeque where we brought seven properties in the Orlando area in an off market transaction under a direct sale leaseback, subject to a master lease. This real estate ranked highly within our casual dining portfolio with strong coverage and a 15 year lease, provided an attractive annual bumps [ph]. We were pleased to partner with a franchises that has a long operating history with Sunny's and we can partner with them to further their growth.
Regarding Shopko, we continue to be encouraged with investor interest in our Shopko locations. We also appreciate that from an overall operations and credit perspective there was increased scrutiny concerning so called big box retailers. And while Shopko is not immune to these competitive challenges we are encouraged with their performance and Shopko's weighted average unit coverage for our portfolio base remained in excess of 2.5 times.
In 2016 we sold nine operating units at a cap rate of 7.5% for proceeds of $78 million. Of the 116 Shopko and [indiscernible] stores remaining in the portfolio, 72 of those are Shopko stores which comprise of approximately 90% of the total Shopko rents.
Regarding the Haggen's investment, we continue to work through the portfolio in order to maximize the value. We sold four vacant stores for $25.2 million and two new stores for $31.4 million at a blended cap rate of 4.5%. The remaining 14 stores include 3 vacant and 11 leased properties that generate $10.7 million in rent.
We continue to participate in an unsecured creditor regarding our bankruptcy claim. The timing of uncertainty of the future payments related to our bankruptcy claims are unclear at this time. As to asset pricing, with the recent changes in interest rates we saw some opportunistic increases in cap rates in the fourth quarter for larger assets.
Smaller assets that are attractive to 1031 buyers continue to trade between 5 and to high 6 cap rates but deal volumes has been more choppy. We made a decision to re-evaluate some of the potential acquisitions during the fourth quarter, while committing to complete existing transactions already in process. At our current cost of capital we are being very selective on new acquisitions and evaluating opportunities within the portfolio to generate earnings.
Finally over the past few months our team has completed a full review of our portfolio and implemented an asset ranking system with the goal of identifying new opportunities for growth. As Tom mentioned we will provide additional insight into the composition of our portfolio, industry views and targets during our investor day in May.
With that I'll turn the call over to Phil.
Thanks, Jackson. During the fourth quarter we maintained our disciplined capital allocation focus while improving our portfolio and earnings quality. While we were positioned to be a modest net acquirer in the fourth quarter investment discipline took precedent. During the quarter we acquired $248.4 million of assets at 7.3% cap rate and we disposed of $271.6 million of assets at a weighted average cap rate of 8.3%, including $205.7 million of assets sold, 84 Lumber and an 8.7% cap rate.
While the 84 Lumber disposition creates a slight earnings headwind for 2017, our portfolio is now better positioned with durable and consistent earnings growth. Before I address our financial results, I would like to point you to some additional financial disclosure that we provided in our fourth quarter supplemental.
As we continue to listen to our stakeholders, we have added incremental disclosure on our public bond financial covenants. We hope that you find this information helpful. As Tom mentioned last evening we reported AFFO of $0.21 per diluted share for the fourth quarter, including adjustments for restructuring charges and other expenses associated with our corporate relocation.
This performance represents a decrease of approximately 5% compared to the fourth quarter of 2015. Decrease is primarily attributable to our balance sheet and portfolio management initiatives, most notably our transition to investment credit balance sheet in our strategic 84 Lumber portfolio disposal. In addition moderate net acquisition activity and the flat same-store rent growth were also contributing factors. As relates to the 84 Lumber transaction, we received additional consideration of approximately $5 million for allowing 84 Lumber to exercise their purchase option early.
This incremental consideration was recognized as a gain on sale and hence not included in AFFO. Balance sheet progress that we've made in 2016 has enabled us to improve our cost of and access to capital as we accretively grow and strengthen our portfolio. Vigilant balance sheet management, disciplined capital allocation and prudent earnings growth will continue to be key strategic objectives in 2017.
Total revenues for the fourth quarter of 2016 increased approximately 3% to $173.4 million compared to a $168.7 million in the fourth quarter of 2015. Primary drivers were moderate acquisition activity during the year-over-year period, higher fee-related other income and a non-cash straight line rent adjustment for previously reserved rents.
Offsetting the positive variance in revenues was loss rent related to lease restructurings and tenant credit loss. Same-store rent growth for the quarter, when compared to the prior year fourth quarter was flat. Rent growth continued to be negatively impacted by an investment in the C store category that has continued to underperform. This particular investment represents less than 1% of our annual in place rents, excellent real estate and its impact on same store results is temporary. As disclosed in our supplemental if this tenant was excluded from our same store portfolio, our recorded same store rent for the year would have been positive a 1.2%.
On the expense front excluding restructuring charges and other expenses associated with our corporate relocation included in G&A, total for 2016 [ph] increased to $184.6 million from $152 million in the same period of 2015. Primarily driving this result was higher property cost and non-cash impairments. Offsetting this was a decrease in cash interest expense, which notably decreased by approximately $10 million during the year-over-year period.
With respect to run-rate G&A excluding corporate relocation charges, it represented 6.8% of total revenues for the quarter in line with our target of at or below 7%. Going forward we do not expect to recognize any further restructuring charges or costs related to our corporate relocation.
As already mentioned, we continued to make great progress on lowering our debt cost of capital. Cash interest expense decreased by approximately 19% compared to the fourth quarter of 2015, solely as a result of our proactive secured debt liability management. In addition our weighted average cash interest rate improved by approximately 35 basis points from the prior fourth quarter and now stands at 4.28%.
Our liability management activities in addition to the investment grade corporate bond market have enabled us to access capital more efficiently. During 2016, we extinguished approximately $883 million of high coupon secured debt, at the weighted average interest rate of 6%. Total cost related to this early retirement of debt approximated $31.7 million or 3.6% of the principal amount of the debt that was retired. More importantly our unencumbered assets base currently stand at $4.8 billion, has increased by approximately $1.7 billion year-over-year. It represents almost 60% of our total real-estate investment.
As of today we only have $345 million of debt coming due through the end of 2018 excluding our $420 million unsecured term loan which is extendable at our option, pursuant to two, one year extension options. In terms of our financial standing our cash flow and leverage metrics continue to trend favorably. Fixed charge coverage improved at 3.6 times versus 2.9 times in the prior fourth quarter.
In addition our fourth quarter reported leverage at 6.2 times improved by 0.7 times from the prior fourth quarter period. We continue to expect to end the year at or below 6.3 turns. However leverage may tick up slightly during the intervening period depending on the timing of capital allocation activity, most notably the timing of asset sales.
Our corporate liquidity remains strong and positions us well for accretive growth. As of December 31, we had $86 million drawn on our $800 million unsecured line of credit. Currently we have approximately $12 million of unrestricted cash and cash equivalents on our balance sheet, and approximately $640 million available under our line of credit. In addition we have approximately $26 million of liquidity available in our 1031 Exchange and Master Trust Notes release accounts there are available to fund real estate investments.
From a liquidity perspective, we are positioning the balance sheet so we are not reliant on the public equity and debt capital markets during 2017. During the quarter we declared a dividend to company stock holders of $87 million, which represented an AFFO account ratio of 85% compared to $77.3 million, representing an AFFO account ratio of 78% in the comparable period a year ago.
In conclusion, we are affirming our 2017 AFFO guidance range of $0.89 to $0.91 per common share. Key drivers of our 2017 guidance range will be disciplined external growth accretive capital recycling as well as harvesting the organic rent growth in our portfolio.
Outlier drivers to keep in mind are the Haggen settlement proceed and our continual focus on our G&A cost reduction specifically related to the internalization of certain services currently provided by third parties. On the Haggen settlement we want to be clear the timing and amount of any payment is uncertain at this time. More succinctly all the related damages related to lost rent, when and if received will go to AFFO, even for those stores that were re-tenanted. As it relates to the lost rent on vacated stores from an AFFO per share perspective it's going to approximate a penny for a fiscal year 2017, if damage claim proceeds are received in 2017.
As in prior quarters the timing of our capital allocation activities will directionally drive our earnings throughout the year. We will continually maintain a focus on improving our cost of capital and maintaining moderate leverage, delivering durable and consistent earnings growth toward continual stakeholder engagement.
With that we’ll be happy to take your questions.
[Operator Instructions] The first question comes from Anthony Paolone of JPMorgan. Please go ahead.
Thanks, good morning. First question is can you touch on the fourth quarter acquisition activity and how it split up between things like investment grade and non-investment grade?
Sure, hey Anthony, it's Jackson. We didn't have a huge amount of investment grade transactions. I would tell you that if you looked at our disclosures, the majority were sale and lease-back transactions as opposed to master lease. So we acquired, for instance a Regal Cinema for instance, couple of camping ruled [ph] assets, we took some - as I talked about the sales leaseback with Sunny's Barbeque, I think the biggest thing that we saw, and I kind of referenced this in our - in my comments, pre-election, post-election we saw kind of a shift in cap rates of at least 25 basis points plus or minus.
And we saw that both basically on the sales side and on the buy side. So we had a number of transactions that we were marketing, that had gotten tied up and if they weren't really buttoned up, buyers came back to [indiscernible] on us. And I would tell you we did the same thing on transactions post-election opportunistically, and we walked away from a number of transactions. So there was a definitely a different break right after the election.
Okay. And then I guess on that thought with you all having paused a bit because of that, does it change the timing or how you think about the acquisitions and dispositions in 2017? So for instance do we see acquisitions maybe delayed a bit, as you guys reset, but dispositions are more frontend loaded, like how do we think about that?
I think it would be kind of similar to the level you saw in the fourth quarter because we've seen a big pick-up in acquisition. It's very interesting, the market in our view, especially in early part of this year has sort of stabilized. And I'll break down the acquisition market in the following kind of terms, 1031 market is completely non-changed. We've been continually finding buyers with the individual small assets that have lined up in that market. I would sort of put bigger portfolios that for public companies requiring them, generally they haven't changed their point of view I would think for the larger quality opportunities.
The area where I think it's still sort of price discovery is if you have a private buyer that's using debt capital to buy a medium sized single property like $20 million and plus range, their financing costs have widened. So I think time will tell where those assets land, but to follow back on your question of investment grade, we locked in - we just closed the Home Depot this week that we had committed to prior to the election, and post - I'll just give you some sense, we've widened that transaction by 25 basis points on that particular asset.
It closed. It an investment grade obviously, Home Depot is a focused tenant of ours. They moved to number 12 in our list right now. We locked into another one that is presumably we're expecting to close very shortly and the cap rate will widened more so definitely than 25 basis points. So I think the takeaway is I think, we - our pipeline in the first quarter and second, I think will be very robust and similar to the way we were sort of approaching business in the third quarter.
Okay. And then does that - there is a comment about just maybe the larger boxes having - requiring a bit more price discovery. Does that inhibit you from putting any Shopkos into the market or are you doing anything on that front right now?
Look, I think as sort of stated goal you've heard us talk about Shopko or any tenant. Having a tenant larger than 5% of our overall tenant roster sort of, to our mind doesn't make sense. The buyer base for Shopko continues to be - we were constructively very positive about it. And so I think you'll continue to see us selectively monetize those assets. The one thing I would tell you is that we are selling Shopkos that are generally lower coverage than our current master lease coverage. So we are kind of very specific as to the type of Shopko assets that we're selling right now versus the ones that were remaining in the master lease.
Okay and last thing from me just on 2017 NOI or central [ph] revenue if you will, where does that look at when the anniversary sort of the matters around that C Store investment?
You had flat core growth in 4Q and the C store investment seem to be a drag, just wondering about 2017 and when you anniversary that and what core growth should look like in 2017?
Look I'll sort of - I'll just sort of take the C store thing right on it, I’ll just tell you right now sort of what the situation there is, and I want to characterize it with we’re going to be very specific and limited on what we can say about it but first and foremost, this is a C store portfolio that’s first of all under a master release. It’s 30 plus stores. It’s really strong real estate. The assets are primarily in Southern California.
The average household income is about 5 mile pop is about 358,000 and household income is about 62,000. Locations are Los Angeles, Huntington Beach, Ontario, Long Beach, Comona [ph] San Francisco, [indiscernible] and Toledo and Portland. So it is really great real estate. The issue we have is the operator. We’re in the process of removing the operator.
Actually they haven’t paid rent since August. We have some recourse for the operator and we also have multiple operators and potential buyers that have approached us on the asset. So the bottom line is we’re trying to resolve it as quickly as we can. We’re very confident in the value and the rentability of those stores. But it’s, we just have to kind of work through it. I can’t really give you a time as to when it’s going to come back online, but obviously we’re moving those cases [ph] carefully as we can to resolve that. But we’re pretty confident about the portfolio.
Okay, got it, thank you.
The next question comes from Alexander Goldfarb of Sandler O’Neill. Please go ahead.
Hey morning down there. Jack just continuing on the C-store tenant. You said they haven’t paid rent since August of 2016. So you guys having been booking any revenue from them since then or you have for GAAP purposes on the presumption that you’ll get paid back.
No Alex its Phil. From a GAAP perspective we’ve offset - we’ve taken a reserve as relates to the straight line rent. So we haven’t been recognizing revenue on that I would say for the fourth quarter and realistically as it relates to go forward strategy, our focus on that tenancy obviously is making sure that we are focused on getting that re-tenanted with a new operator and have income going forward, but from that perspective, no.?
And look I don't want to make light of it, it’s less than 1% of our total rent. We don’t like the fact that they’re not paying, but again a lot of complex [indiscernible] to know that these are really the very, very attractive C store locations on really visible four corners, in the right market. So we’ve already been proactively approached by a number of different operators and potential buyers of the asset, and we’re going to kind of methodically do the best we can to maximize value and actually get these things back online. Basically this is very good real estate.
Okay, so I mean if we look at it from a perspective of boxes [ph] I think in total you have 46 empty boxes plus this chain I guess of 30 C-stores that you are looking to replace with a different operator. Yet we heard from the Strips what they’re looking to back fill some of their vacancies, Goldsmith [ph] their sports authority whatever, it seems to be like a nine to 12 month process in total.
In your view as you guys look at your available space, should we think about something similar where it's almost about year between when you have a store you’ve, not renewing go-dark or you’re trying to replace an operator that is sort of a 12 month timeframe or is it longer, shorter, just how do we think about the time, the backdrop, some of these spaces and the drag on the portfolio?
Well I would say one thing, this is just something that wouldn't be coming in new. I think we’re going to be more efficient at dealing with vacancy, because you can - it's kind of a push pull, you can kind of hang on too long, to try to get that actually dollar or actually $0.10. And there’s a cost implicit in sort of just holding it vacant. So there's a trade-off right because there’s a quick fix and then there’s one that’s sort of longer term that may create more value.
The vacancy in this particular C store location is really a different circumstance of what I’ll maybe some of the vacancy we have in some of the other locations where it might be a single location you’re trying to re-tenant something. This is sort of an operating portfolio that’s [indiscernible]. And so it’s just a question of - I can’t get too specific on that particular portfolio because like I said we are in the process of removing the operator. But I feel very confident that these will get resolved very quickly and this relates to that portfolio. It is vacant. It’s currently not on our vacancy list right now because the lease is still in effect right now.
Right, but as far as the remaining 46 are those spaces that we should expect to be filled as we look to 2017. Or we should think about that’s NOI that will remain absent from 2017?
I think you could expect us to resolve those vacancies probably from a historical standpoint much faster. Either being sold or leased.
It's high priority that I put on the asset management team. Because I think that, there is obviously a lot of different things people can do with their time, blend extend [ph], sell property. Vacancy is like a real KPI in that group right now and so they are - even though it's a very small portion of the portfolio, there is a lot effort being put into resolving those matters in a more expeditious fashion.
Okay. And then my second question is, Jackson sounded like from your comments on transaction market like sort of cap rate - things have settled back down and that you expect at least the first half to almost be a catch period. But I think Phil, you’ve mentioned not planning to access either the debt or equity markets this year. As we think about you guys funding some dispositions, you guys have long spoken about sort of that investment grade, bucket, the drug store type, the flat leases that you look to harvest at low cap rates.
Can you just update us on how much of that product is available, as we think about your guys ability to acquire, we can think about how much that you potentially have to sell in order to fund the acquisitions this year.
Let me just start and Jackson can talk about the assets that we would be targeting for this position in ‘17 but you know one thing to keep in the mind and one think I referred to on our call is that, the timing of capital allocation activities as well as the fact that leverage is expected to moderately increased during the first half for the year. That’s directionally going to drive our earnings and capital allocation plan.
So I would not be looking at it from the perspective of having asset sales and accretive capital recycling being the sole driver of our external growth. We’ll moderately leverage into the year, but as I mentioned in my prepared remarks as well, we are totally comfortable with our leverage guidance at or below 6.3 turns.
And I'll - look we already kind of new team here down here and as you know if you buy - your timing of their acquisition are the big impact obviously on earnings for the year. And we are very cognizant of it. So I would say that our first, we took a bit of pause like post-election we were very aggressive on deals that were not signed up that we want to buy.
We were prepared to move forward, but it had to be kind of revised pricing. And I would tell you that, on things that we were selling when we were getting re-traded and I believe specifically there were couple of Haggen assets that were locked in very attractive prices. Guys came back, re-trade to us, we said, no.
So we only ended up selling one at the end of the year which was you Eugene [ph]. We think that the markets have begun to stabilize for those high quality, well I'll call it, investment great type assets. So we caught a couple of them pretty attractively, that are kind of going to transpire early in January and February closings, that we picked up. But there were number of deals that we walked away from as well just --.
Okay, listen, I appreciate it. Thank you.
We ask that you limit your questions to one and a follow up. The next question is from David Corak of FBR Capital Markets. Please go ahead.
Hey, good morning guys. Just a quick one on for Phil. In terms of your leverage position today, how are you balancing potential repurchasing shares, given the stock price with maintaining your position with the rating agencies and then may be just some color on the metrics and the math that you guys are focused on right now when, even when you are considering a buyback?
Well from a share buyback perspective, that’s clearly based on fact or circumstance at that point in time. We are no different than any other REIT from the standpoint that there's a number of REITs out there that have the share repurchase programs in place. And as you know the large majority of REITs do not use those programs. So and obviously direction - I can’t talk about the math in terms of when we would consider buying back shares but we as a management team, obviously look at our company from an NAV perspective continually and we have a very good grasp of when we would consider entering in the market announce that at that point in time.
Your question as it relates to leverage, I think when we are talking about it with the agencies, one thing to keep in mind is that we speak with the rating agencies very frequently on a quarterly basis. We as a management team are going out there in the first quarter which we always do, to kind of show them our capital plan for the year. And in connection with that, the agencies are aware the fact that we anticipate ending the year at or below 6.3 turns.
Directionally we are going to be obviously speaking with them in terms of yes leverage may moderately tick up throughout the year, but on the back half for the year we do see leverage coming down again at or below 6.3 turns, and when you look at leverage today, I think stuff - what people lose sight of, and again when we look at leverage, we’re looking at debt plus preferred to EBITDA, and I think people are coming around to that view on leverage. We compare very favorably with our peer set. We are all in the same zip code right now. So…
Okay, great. Thanks guys.
The next question comes from Haendel St. Juste of Mizuho. Please go ahead.
Haendel St. Juste
Hey, good morning guys. So I guess my question is understanding your plan here focused on some of your lower cap rate, low growth assets and acquiring higher yielding assets which will in turn you help your earnings in the short run. Just curious how you’re balancing that earnings benefit versus the risk of these high yielding assets, the lower credit tenants involved [ph] and also to the impact on your pro forma NAV as part of your investment, capital allocation decision here?
Well, I’ll start kind of just. So when you talk about sort of higher yielding assets, when we’re looking higher yielding assets, they are generally non-investment grade, right. So but if you buy an investment grade unit, you don’t get a master lease generally, you don’t get unit coverage, you don’t get really great sales visibility potentially on that particular property because the tenants don't need to do that.
If you are dealing with a non-investment grade tenant, in some of our master lease, in a critical essential asset like restaurant portfolio or gym portfolio, I mean you’re going to get things that structurally will help you quite a bit. And so the question for us is, is it the right location, is it the right operators, is it the right rent per square foot, is it the right concept.
And that’s what we kind of look at when we balance investment grade versus non-investment grade, because look the non-investment grades assets if they are bought properly with the right underwriting criteria, the structural benefits you get from visibility and master leases very, very powerful, as it relates to if something goes wrong and look - case in point there is - there were lot of investment grade big box retailers that quite honestly have gone through a lot of change where if you are not ahead of that and they are not going to tell you if it's challenging.
Yeah, and I would just want to I guess embellish on that. This is Tom speaking. This is something we talk about internally all the time. I am not here to suggest the laws of investing don’t apply, in another words higher yield and higher beta and higher alpha doesn’t mean higher beta, we are not suggesting that. But on an episodic basis, and on a one-off basis, we are looking at some of the assets that we’re selling, and one of the ones that we’re buying and we are prepared to make that trade and believe we are actually enhancing the portfolio characteristics and yet we are making a lower cap rate sale for a higher cap rate buy.
Now again in general that's not the laws of investing and I understand that, but for a certain of that assets that we’re selling, we believe that, that is in fact the case. One of the things to think about in that regard as well, is that as Jackson mentioned, the 1031 market is very vibrant right now. Case in point, if we just talk about Walgreen's for example, we could have a Walgreen's in our portfolio that’s coming up on 10 year remaining left in the lease term, is a flat lease and there is very strong bid in the 1031 market for that.
So obviously if that’s not a core asset for us from that perspective, rather a flat lease we're not really comfortable with the renewal process right, something is going to pay us an attractive cap rate, that’s a good trade for us as well.
Haendel St. Juste
Appreciate the color guys. One more follow-up by me. So I guess as part of your underwriting these newer tenancies, higher using tenants we were just discussing, are you acquiring are you getting unit level coverage and maybe you could share with us perhaps some additional things you are requiring here, and if you're able to get what compare and contrast perhaps the rent bumps you are getting on these versus the older assets you're selling?
Sure. Well, I'll use Sunny's, that's a good example. So and I put that in the category of not super high yielding, but directionally sort of things that we look at. So this was a situation where really good real estate, five of the locations - four of the locations were in Orlando, couple two were in Gainesville, the other was in Florida as well.
This particular franchisee, that was buying this property that we had bought from, the COO of Sunny's was joining up at this particular existing franchisee. Five of the seven assets that we're buying and getting renovated, the new kind of facelift that Sunny's putting out there. So we bought this deal at basically two times coverage, old units.
This was basically company owned stores being sold to a new franchisee, which was a former COO in an existing 17-year franchisee. So they're going to put on a couple of million dollars face lifting five of the seven. That coverage just anecdotally on rebrands that the existing franchise experience was like 10% to 13% uplift post, post facelift.
So to me, or to us that has bumps that master lease, it's got a renovation going on, it’s got very, very high VPDs and population - good, good population demographic growth around those units. And those - that would be north of a seven plus percent cap rate and get improving coverage as time goes on.
And those are kind of deals that we'll probably - you will see us do more rather of and this particular franchisee is rolling out more locations for Sunny's. We'll kind of on a case by case look at bringing more of those into the master lease.
Haendel St. Juste
The next question is from Daniel Donlan of Ladenburg Thalmann. Please go ahead.
Thank you and good morning. I just have three quick housekeeping questions and one Shopko question with a very quick answer. Your coverage for Shopko, you said about 2.5 times, is that as of the third quarter or the fourth quarter on a trailing 12 basis?
That's of the third quarter, because they are our fiscal fourth. We haven’t seen a fourth quarter number, so that's third quarter.
Okay, thanks. The - and as far as guidance goes, what's embedded in Phil in terms of other income and interest from real estate transactions?
Yeah. Dan for that I would assume 1% of cash rent is typically a good proxy. So anywhere from $6 million to $7 million.
Okay. And then Shopko, do you guys get a 6% bump, started in September, is that correct, am I remembering that right?
No, Dan, when we restructured the lease with Shopko as you may recall, we did that in order to facilitate the sales that we've been ongoing. We've - we converted the 6% every three years to effectively 2% every year. So we went from every three years to every year and so for this year, we've got a 2% bump, I think it's 1.95%.
Yeah. And it happened in January.
Yeah. And it was effective January 1st.
Okay. Okay very, very helpful. And then last one from me, just looking at your acquisitions in the fourth quarter kind of relative to prior quarters, and your cap rate came down from about 8.1% in the first quarter down to 7.35%, and sale lease back transactions and master leases as a percentage of rents also came down versus historical metrics that we could find. So just kind of curious as - I think maybe you eluded to it a little bit in your prepared remarks, but is this kind of a shift in strategy, or is - was this kind of fourth quarter aberration and you'd to expect not only cap rates move back up, but percentage of sale lease back and master leases to move back up as well?
Well, I will start, I think the fourth quarter was again an unusual quarter for us. We saw real direct visibility because we're big seller of property obviously. The market changed, we obviously had a decline in our cost of capital as well. And so we took the course that things that were sort of not bucking down before election, had certain kind of price reaction from us. And I would say also - I think without getting specific in terms of the things that we bought, I think we bought actually better quality single unit opportunities.
And I think we're going see us have a balance of - focusing on that as well as sort of our core strength of enhancing the non-investment grade portions of our portfolio. So for instance Home Depot we're just closed that last week. I mean that transaction was buttoned up two days after the election, the one that we just closed on. And we think we've got a very attractive price relative to where these things trade and we're going to be very moderate as to how we think about that. But they will become one of our top 10 tenants very shortly.
Okay, appreciate the color.
The next question is from Michael Knott of Green Street Advisors. Please go ahead.
Hey guys. Tom thanks for the immunity announcements. Appreciate that, and just wanted to ask if you wanted to - if you cared to elaborate on your thought process on that decision, any more beyond what you already said just in terms of how you thought about reaching that conclusion.
No, I'm happy and I don't think there is too much to elaborate. I guess I'd offer two thoughts. I think the first thought is when we've been asked about this before, I think one of my responses is that we take governance exceptionally seriously. We think we have a terrific Board of directors, nine members, eight independent. We think we have excellent governance and something that we prior ourselves in.
What we said was - this is something we look annually. We look at all our governance provisions annually. And well I realize there is immunity on this particular topic as to the benefits or cost associated with it. I think our view in discussions internally and this was again purely an internal process, our view was the prevailing wisdom is that the shift is more towards better and more transparent and more accountable governance. And that was where we want to be held in the REIT industry. And so that was the judgment our nominating governance and board REIT and we were happy to do so.
Okay thanks and then just curious how you're thinking about your cost of capital today. And how that is influencing, how you're think about your acquisition disposition activity in 2017. I think commentary today has touched on this question a little bit here and there but just wanted to ask you in that particular manner, thanks.
I think I would hope that when history judges us over the last couple of years, I think we've gotten good grades for how we've allocated capital, when we've accessed the market, how we've accessed the market both on a debt and equity standpoint, how we've recycled the capital. We obviously study our cost of capital, we also want to stand at that's a spot analysis. Your cost of capital today could be dramatically different two months from now. We believe that we have an opportunity to dramatically improve our cost of capital with all of the enhancements that the company has gone through over the last year. I touched on in my remarks, balance sheet, the investment grade, the fact that as Phil pointed out we're right on top of our peers.
We weren't in the same zip code with our peers over a year ago. The portfolio changes, again I would suggest people look at our top 20 tenancy today versus the top 20 tenancy two years ago and it's a dramatic improvement in the relative quality of the portfolio. So this company has a real opportunity to improve its cost of capital. I would point to the fact that we did our first de novo bond offering. And at that time we paid the entry fee, came out a little bit wider because you're a de novo operator. We've seen those spreads tighten as companies and as the folks who are on that debt have gotten to know the company better.
I realized equity multiples and debt spreads are - there are different contingencies but there is a lesson learned there in terms of the fact that as people get to see the changes and improvements that we've made to the company, that we think that it’s a real opportunity for cost of capital improvement. And that’s what we're going to be driving forward in 2017.
In the meantime we're going to be very prudent about how we use our capital, how we access the capital markets and if - when we see opportunities to grow AFFO we're going to do it. And again I think that's what's been - what we've been doing successfully I think for the last three years.
Thanks, and a quick follow up to your comments there would be if you do achieve a better cost of capital going forward, particularly on the equity side, do you feel like that would cause you to be more aggressive on acquisitions or do you feel like you are confident enough regarding to go ahead and incorporate that type of stock process in to your acquisition activity today?
I think you always need to be studying your cost of capital. It is one of the elements that goes into the thought process of both how aggressive you want to be, and any element, whether it be acquisitions or dispositions. I don’t think it pays to be dogmatic. I think it pays to be looking at it constantly and making the right decisions at the right time with both of your cost of capital and the opportunities that you have to acquire property and the enhancements that you have to make to the portfolio. I mean Jackson talks about these [indiscernible].
That's a nice upgrade in terms of our top 10 tenancy and we are going to continue to do that and we can do it - we can do that easily with our existing cost of capital, we can continue to improve this portfolio with our existing cost of capital.
Yeah, I mean just to reiterate, we sold a couple of the Haggen’s assets and we think about selling Haggen’s how do you want to redeploy, do you want to buy a non-investment grade, casual diner, on a master lease or you want to focus on the critical tenant that you believe has legs. We very strongly believe in Home Depot right now. So when we are thinking about that calculus we knew we had a certain number of Haggen’s properties that we are focused on settling, they are going to be very aggressive cap rates. And so we looked at that as an accretive idea - as opportunity.
And I will just put out, just my two cents on cost of capital, with now almost six months end of the opportunity, this company has more opportunity in my opinion relative and I look at sort of our peer set in terms of their differential of cost of capital. I hope that when we have a chance to really take people through our business plan in May, I’m very confident that we are going to be able to close the gap on the cost of capital, and you will see us of course not only increase our acquisitions volume aggressively in total.
One thing I was just add on the cost of capital is - and again if you just look at our debt cost to capital, and as Tom was mentioned our de novo bond offering. Since we’ve did that offering our spreads have come in about 50 basis points.
The other thing to mention is that Tom, Jackson and I run a non-deal road show. We met with 24 fixed income investors in April - I’m sorry in January. Just post that those meetings our spreads came in another 25 basis points. So from that perspective when you are looking at our overall cost of capital and alluding to what Jack was talking about here, the opportunities we have in terms of improving our cost of capital I think sometimes is not really taken in to consideration by the Street we have a tremendous opportunity here to continually improve our cost and capital more so than our peers I think.
And look I think our cost and capital you earn it right. So I think that what we will share with you soon is that sort of the new leadership direction focus and I will tell you like intensity that this brought to this organization and rigor. I hope it's very clear to you when you see in May, and like I said we’ve got to prove to people that we deserve it. I think we will prove it. So we’re going to continue to march on.
The next question is from Vikram Malhotra of Morgan Stanley. Please go ahead.
Hi guys this is Landon Park on for Vikram. Just want to touch base on the impairment that you guys took in the quarter. It was very large, just wondering the details on that and if it relates in any way to the portfolio or view that Jackson had undertaken?
Hi, Landon, it’s Phil. Yeah, I would say [indiscernible] was part of the portfolio review that Jackson went through. I would say that - what the impairments that we’ve recognize this quarter, we wouldn’t expect this to be a run rate trend. We did have a very deliberate focus on property cost leakage and getting underperforming assets out of our portfolio. That was clearly what was driving the majority of these impairments that we’ve recognized in Q4.
But I think as you are looking forward to 2017 and as Jackson alluded to in terms of the port - the disposal that we will be looking to do in 2017 some of them are going to be these underperforming assets that are contributors to this property cost leakage. We are very vigilant on reducing that leakage and then also some of the disposals that we’re looking at this year are just accretive dispositions as well.
I mean just - and I think people know the process for impairments but when you take an asset from held for lease to held for sale, that almost always kind of triggers an impairment and we did as part of this portfolio review process and Jackson's alluded to this already, we’re trying to be more aggressive in terms of dealing with vacant properties because they contribute negative AFFO. We’ve got carry costs associated with them and they have been vacant for a long period of time. And so we have been more aggressive on this and as a result of that aggressiveness, the irony is that it creates an impairment.
But it's an impairment on AFFO negative asset. So from our perspective it's certainly not a negative on the business. It's really a reflection on us being more aggressive from a portfolio management standpoint.
Okay great. And then just a quick follow-up on those comments. Just is there anything, any single tenant or single asset that makes up a large chunk of the impairment? And then just going forward may be can you provide a bit of size of the opportunity on the asset recycling portfolio repositioning side, maybe a multiyear potential target for the portfolio?
Well look, on the impairment side I think, there is not one outlier that’s kind of driving the impairment that we recognized in the quarter and then I know I guess first I didn't understand your second question. So -
What is the planned disposition, asset recycling program over the next several years, in terms of…
I think what the way we’re look at it and - look these assets you can’t sort of, as you guys know, giving anecdotally, we just - I just approved the sale yesterday of a Red Lobster, [indiscernible] Tennessee at a 5.85 [ph] cap rate. It's part of the master lease. For our reason it made sense to sell that property and not just because it's a 5.85 cap rate but kind of given some of the dynamics around that property within the master lease.
There is other opportunities, we’re in the process of doing a blend and expand right now with Walgreen's. There are some stores when we get that expansion we will probably monetize but it's not a wholesale decision that we do right now. So part of it is I would say improvement within the portfolio, some of its defensive, some of is opportunistic and there is lead time that’s involved with all these decisions. So I think we do have a plan on this dispositions, but we’re also mindful of that being kind of a churn shop because that has impact on earnings.
So but all these decision on dispo, in some ways the third quarter disposition and the fourth quarter dispositions, a lot of that decisions were made in the first, second quarter of last year. So we’re really trying to with the kind of new scheme and focus that we have really you’ll see more of that disposition activity really come to life probably in the third fourth quarter, things that we, we kind of pursue some of the stuff.
Okay, thanks for that color.
The next question is from Ki Bin Kim of SunTrust. Please go ahead.
Ki Bin Kim
Thanks, good morning everyone. Just a broader question for Jackson. What are some of the things that you’re trying to change or improve at Spirit whether it comes - whether it deals with how you deal with tenants or how you look to buy and sell things, just trying to get a larger sense of what might be forthcoming from Spirit Realty.
Well look, my background obviously coming from the banking side, is sort of very data driven, customer driven right. I dealt all my career with dealing with customers and boards and giving advice. I would say that what I would like to see improve in this organization, much more customer engagement, number one, much more analytical rigor as it relates to how we analyze things and just much more intensity. I came from intense place, much more intensity as it relates to buying, selling, just making - just doing our job basically.
Ki Bin Kim
I didn’t think Morgan Stanley was that intense a place.
As I say, you will always be closing, whether we’re buying, selling or trying to create value. So…
Speaking as the CEO working with Jackson and I can say I think Jackson's brought a wonderful perspective of portfolio management and engagement, and it's not to suggest that the company wasn't a portfolio management company. You’ve heard me talk about it for years but what you’ll see I think at the May meeting is far better analytics, far better presentation capability, far better, both internal capability for us to see forward and to see around corners and to make decisions about the portfolio, I think in a more informed fashion and a more analytical fashion.
And Jackson has done, from my perspective, really a wonderful job working with the team here to put us in a position and I think we’re going to showcase that in May and I expect and hope that will be well received by investors.
Ki Bin Kim
Okay and how are the duties or responsibilities kind of split between you Tom, and Jackson and what happens in terms of if there are disagreements, in terms of when you’re buying or selling how do things - how do those things get navigated around?
I mean I think one of the things that I’ve encouraged and - is a robust investment committee process. And again the changes that I’ve made, Jackson is not the only addition to the executive management team here over the last 18 months. I think there’s been substantial additions at - through the work that I have done in terms of attracting talent to the organization. We have a robust investment committee discussion and people’s perspective and our investment committee operates in a way that you would expect through attempting to reach a consensus but I do have the discretion as the CEO.
I do have a veto, that’s what you’d want to call it. I don’t tend to look at it that way. What I tend to look at it is it's my job to set the investment strategy and direction of this company. That is my job. And working with Jackson very closely and we spend a tremendous amount of time together, he and I look at that strategy and we obviously we talk about it and then Jackson and his team are working with me to implement it.
But that’s really the relationship and I think this company has benefited from again the talent, the executive talent that we’ve drawn to this company in the last 18 months is a big reason that we’re in the position that we’re in. today. That’s why we all sense the opportunity we have here again and I think looking and I point people to it’s not as if we haven’t been making progress along the way. I point to the balance sheet, I point to the portfolio but now with this talent in place, we’re in a position to take it somewhere.
Ki Bin Kim
Okay, thank you.
The next question is from Joshua Dennerlein of Bank of America Merrill Lynch. Please go ahead.
Hey good morning guys. I saw that you purchased three office assets in the fourth quarter. Talk about the rationale behind that and then what’s your appetite for more? And do you have a limit on how much total portfolio could be office?
Yeah hi this is Boyd. Yeah, I mean historically Spirit has always had medical office, industrial, along with retail and other, for - I mean we look at the opportunities as they come available and make decisions what’s best for the portfolio. I think we will always continue to look at medical office opportunities, we will certainly look at industrial, retail in segments that are accretive to the portfolio, both from a [indiscernible] standpoint and from a diversification standpoint.
Yeah so those office buildings were medical and emergency centers that were in the fourth quarter, not traditional office.
Yeah and just to be clear and although we’ve said this before mean I know in the triple net sector some folks do categorize suburban office that happens to be leased long term to a long term 15 year lease. They consider that triple net investing. That is not a priority. For this investment strategy never has been - I view that as suburban office, that happens to have a longer lease.
So when you hear office from us it’s generally refers to some sort of specialty in this case, it's medical office.
Okay, thanks for clarifying that. And then just on the C stores, just a question where the in-place rent's - the current market rents for that portfolio? The in place rents of the two high competitive markets, [indiscernible] that the one to do with the difficulties of operator.
No, it’s not really a rent issue, but it’s I really, like I said, I don't want to get - we've sort of said as much as I think we can say as it relates to that portfolio. What I would tell you is, given those locations urban in-fill high density, high population areas, rents for C stores are very high for those relative to rule.
So I don’t think it's a question of the rent necessary but operations. Operations, that’s really what - that was - that's the issue.
Okay, thanks for that. I am good.
The next question is from Rob Stevenson of Janney. Please go ahead.
Good morning guys. Can you talk a little bit about, given your comments earlier understanding that it’s a under master lease, but what’s the level of Shopko, the 116 Shopko assets that are meaningfully below the 2.5 times average coverage ratio?
Well first of all, we have a master lease. So as you kind of think about a master lease we have rents allocated. But it’s one big rent.
I think one of the comments - we have made this - we’ve made this comment before relative to this question, we can’t give out individual store performance, given the requirements of confidentiality in the lease. What we have said and it remains consistent today is that the Shopko performance within these boxes given their locations, mid-west locations they tend to be on relatively tight bell curve. There aren't a lot of weak performances and there aren't a lot of rock star performance. It tends to be a pretty steady state portfolio around the relatively tight bell curve, around the general average for the
The biggest thing we have going for us too is the rents are low.
Really, the rents are really low. We are going to talk when we get to Investor Day more about, Shopko, there are some opportunities there. I'' just leave it at that. But we are very comfortable, we talk to Shopko a lot, just to see them [ph]. And they are doing very well in the locations that we are continuing to maintain very, very good real estate locations. Good access, lot of retailers nearby, they’re profitable. So I think to Tom’s point, the coverage range feels very moderate. It's very, very close to medium.
Okay. And then in the 46 vacant assets as of December 31st, what the sort of thought processes in terms of today, in terms of percentage, in terms of re-lease versus wind up selling .And Phil, what’s the instead of implied drag on earnings from a taxes, utilities maintenance et cetera for having have sort of vacancy on those units right now?
Well, look. Let me just take the I guess the leakage aspect of things. What I've always told people is that and I tend to just triangulate to cash rents, kind of what we show on our NAV page. When I look at property cost leakage, I always say it can approximate anywhere from 1.5% to 2% of cash rents. And as I said earlier part of the exercise that Jackson went through which was going through the portfolio, is that we definitely could be more vigilant in terms of reducing that property cost leakage numbers.
So I do see us - I mean that's the range I’ll give you in terms of property cost leakage. Rest assured that our goal is at the low end of that but it could be as high as the 2% number.
Okay, and then I mean what is the - today, I mean what’s the thought in terms of that 46 or whatever it is today, how much are likely to be re-leased versus likely to be - more likely to be sold?
It’s hard to say - to give you a really good percentage, I mean we - because generally what we are looking at mitigating a vacancy at that point, look if we could have worked with the existing tenant, there's a lot of different ways we could do that and not make it go vacant but once we had made the decision to go vacant, we look at re-leasing as an option potentially, we looking sales and sort of just, it just really kind of depends on the net present value between those two opportunities.
So it’s hard to give a real straight percentage. I think what I would tell you is that there generally wasn’t a KPI as it relates to vacancy greater than 12 months. I'll just leave it at that, and there is now. I think there is a trade off when a vacancy goes beyond 12 months. Sometimes, - I think that has - you got to kind of balance short term, quick fix, versus having some hang around the roof for 24 months. And trying to hold on for maximum values.
So there is a trade-off there. So, it’s hard to give kind of a percentage but look we do have vacancy, we don’t just kind of pump right away. And we try to kind of give - I will just say there is a lot more attention right now being put on kind of trying to get the best alternative from a net present value for us, whether it be a sale or re-lease.
Okay. Thanks guys.
There are no additional questions at this time. This concludes our question-and-answer session. I would like to turn the conference back over to Tom Nolan for closing remarks.
Thank you and thank you all for your time this morning and as always for your interest in Spirit Realty. We are pleased with our progressed over the past year and we’re very excited by the opportunities we see ahead for us in 2017. We look toward to speaking with you all again soon. Thank you.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.
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