Essential Properties: Rising Cash-On-Cash Returns, But Beware Of Emerging Risks (EPRT)

Essential Properties Realty Trust, Inc. (NYSE:EPRT), unlike many other real estate investment trusts, or REITs, has held up quite well this year, suggesting it possesses significant idiosyncratic strengths. Global and U.S. REITs alike have suffered since the turn of the year as disinflation coupled with economic tail risk has acted unfavorably against the sub-asset class. Moreover, commercial REITs have endured rising risk premiums, sending their valuations into a tizzy. Nevertheless, Essential Properties Realty Trust has held up well and, as such, provides an interesting topic of discussion.

Today’s analysis looks at the REIT’s underlying potential coupled with its market-based prospects. Let’s traverse into a deeper analysis of Essential Properties Realty Trust to find out what is in store.

Assessing Escalations and Property Valuation Prospects

Business Model Overview

For those unaware, Essential Properties Realty Trust operates a single-tenant commercial real estate model, which primarily includes tenants operating in the services sector. A strong value proposition is the REIT’s diversification, as its top 10 tenants span merely 17.1% of its portfolio. Although we generally consider this REIT low-risk (for a commercial asset), it still possesses significant cyclicality, lending us an interesting debate in today’s analysis.

Further, I would like to highlight Essential Property Realty Trust’s sales-leaseback program. The program adds high-yield prospects to the REIT’s core investment portfolio, especially during distressed economic periods, as it provides liquidity to firms who subsequently lease back the properties at elevated rates.

Rising Cash-on-Cash Returns

The term cash-on-cash returns refers to a real estate investor’s net of debt internal rate of return. However, for the purposes of today’s article, cash-on-cash returns refer to the cash-based capitalization rate, which is the net of debt rental yield an asset provides relative to its purchase price.

As visible in the diagram below, Essential Properties Realty Trust’s cash and normal cap rates proliferated during its latest financial quarter. In my view, this is an incredible feature as risk factors such as disinflation and rising variable interest rates are crushing commercial cap rates within the United States. Although disinflation poses a continued risk to Essential Properties Trust, a continuous extension of lease terms and weighted average lease escalation coupled with high occupancy suggests that lucrative cap rates might continue into the next few years.

Much of the REIT’s recent increases in capitalization rates have occurred due to low-cap rate dispositions and new acquisitions. For instance, during its latest quarter, Essential Properties Realty Trust disposed of a bunch of properties, which yielded an average capitalization rate of 6.1%. Sure, the REIT realized a 2% incremental loss on the units; however, it used some of the proceeds and enhanced its asset base with 78 acquisitions, averaging capitalization rates of 7.14% and an average lease term of 19.3 years. In my view, disposing of older assets and buying new assets in today’s distressed environment provides significant potential for future capital gains.

Lastly, let us briefly consider Essential Properties Realty Trust’s capital structure. Here we have a vehicle acquiring assets with a weighted average borrowing rate of 3.3%, which is less than half the value of its portfolio’s capitalization rate. Moreover, the REIT’s EBITDA covers its interest obligations by 4.1x annually, which I think is superb. However, I concede that its short-dated maturity schedule is of concern as it raises the possibility of frequent recapitalization (at unknown rates).

Real Valuation Risk Factors

Although Essential Properties Realty Trust’s escalation prospects seem bright, its property valuations might suffer a beating in today’s disinflationary environment. A hedonic view can be formulated by comparing the recent decline in U.S. commercial REIT valuations with Essential Properties Realty Trust’s Q2 disposition losses. Moreover, a likelihood of a continued decline in U.S. inflation might cause devaluations within EPRT’s portfolio; in addition, the REIT’s tenants might experience diminishing nominal cash flows, leading to lower asset-specific valuations.

Furthermore, Essential Properties Realty Trust holds high exposure to cyclical industries, as seen in the diagram below. Pearl Gray Equity and Research, including myself, believe that cyclical risk will continue to rise until interest rates dip below the midpoint; as such, higher future vacancy might come into play, concurrently depleting individual asset valuations.

Big Risk Factor: EPRT REIT Valuation and Dividends

I might be wrong, but Essential Properties Realty Trust seems overvalued from a market-based perspective. Firstly, the REIT’s price-to-adjusted funds from operations and price-to-funds from operations are both above their cyclical averages. Moreover, my absolute valuation shows the REIT possesses a fair value of $5.89 per share based on a per share AFFO and sector median price-to-AFFO multiplier.

Furthermore, although Essential Properties Realty Trust pays a fair dividend (relative to its sector peers), I fail to see how the dividend will compensate for the REIT’s valuation-based risks.

Final Word

Today’s analysis shows that Essential Properties Realty Trust’s cash-based capitalization rates remain robust amid nimble disposition and low borrowing rates. However, a hedonic vantage point suggests the REIT’s underlying assets face valuation headwinds as most other U.S. commercial REITs do.

Lastly, an absolute valuation of Essential Properties Realty Trust suggests it is overvalued. Moreover, although lucrative in isolation, the REIT’s dividend probably won’t compensate for its mispricing.

Consensus: Hold Rating assigned with a 12-month holding period in mind.