Essential Properties: 4% Yield And A Trillion-Dollar Tailwind (NYSE:EPRT)

An Introduction (About SLBs)

What’s one of the biggest trends in commercial real estate?

The answer is sale-leasebacks, also known as SLB transactions.

Realty Income (O), the largest net lease REIT in the world, estimates that the SLB market offers opportunities of more than $1.6 trillion – among S&P 500 companies alone!

So, what’s a sale-leaseback transaction?

According to JANOVER (emphasis added):

In commercial real estate, a sale leaseback is a transaction in which one party sells a property and then leases that property back from the new owner. Sale leasebacks usually involve a pre-arranged contract, which often lasts 20 to 30 years. Sale leasebacks are especially helpful for business owners who are holding onto expensive retail or office property, but have cash flow problems or need equity to expand their business.

For example, let’s assume I own a building in The Woodlands in Texas. I use that building to produce and sell pizzas. I do it so well that people keep telling me to expand.

The problem is: I don’t have the cash to expand.

However, I have a building in what could be the second-best city to live in America. In other words, we can assume that it has gained substantial value since the pandemic, including the migration to tax-favorable states like Texas.

A sale-leaseback option may be perfect for me.

Going back to the JANOVER definition of an SLB transaction, in order to expand, I sell my building to a landlord.

This deal gets me a huge amount of cash I can use to expand my pizza business, including buying property in neighboring cities.

A deal like this makes a lot of sense to me.

• I do not have to ask the bank for an expensive loan. After all, with Fed rates north of 5%, I’m looking at a very expensive rate on my debt.
• The fact that I own an expensive building does not add much value. Why not unlock value to expand?

The one thing that changed is that I now have to pay rent to my landlord. That’s why SLB deals are somewhat comparable to loans. Instead of paying interest, companies pay rent.

Unfortunately, the downside is that once the lease term ends, I have no ownership interest in the property. I’ll have to get a lease extension, repurchase the property, or move.

I’m bringing all of this up because SLB deals are becoming increasingly common. The Tractor Supply Company (TSCO), one of the fastest-growing retailers in the United States, uses these deals.

Additionally, we plan to continue to leverage our sale-leaseback program on both existing owned stores as well as future new store openings. This program will help fund our planned owned store development. We plan to execute sale-leaseback transactions of our existing portfolio of owned stores to fund the cash required by the new development program over the next eight to 10 years. – TSCO 2023 10-K

Especially in an environment of elevated rates, SLB deals are becoming attractive as companies want to avoid adding expensive debt to their balance sheets.

Using Realty Income’s example, we see there are many ways a company can use SLB to its advantage, including balance sheet de-leverage.

While I like Realty Income, my favorite stock for SLB deals is Essential Properties Realty Trust (NYSE:EPRT).

With a $4.7 billion market cap, it’s one of the smallest net lease REITs on the market, which comes with benefits as the company grows through smaller deals.

Unlike its bigger peers, it does not need massive M&A deals to grow.

My most recent article on this company was written on February 22, when I wrote the following:

While market conditions may fluctuate, EPRT presents an enticing opportunity for long-term investors seeking a reliable income stream and capital appreciation.

Since then, EPRT has returned 11%, beating the 2% return of the S&P 500 by a wide margin.

Since its IPO in 2018, the REIT has returned roughly 160%, beating the Vanguard Real Estate ETF’s (VNQ) 26% return by more than 130 points.

In this article, I’ll walk you through the EPRT business model and explain why I continue to be a fan of this rapidly growing REIT – focusing on SLB and new developments, including its Q1’24 earnings.

So, let’s get to it!

What Makes EPRT So Special

As its name already gives away, EPRT is a business focused on building relationships with tenants in essential industries – the kind of industries that do well even if the economy falls off a cliff.

Founded in 2016, this internally managed REIT focuses on properties that are mainly occupied by middle-market companies engaged in service-oriented or experience-based businesses.

For clarity, a “middle-market” company is defined as one with annual revenues ranging from $20 million to $1 billion.

As of December 31, 2023, the company’s portfolio consisted of 1,873 properties with a 99.8% occupancy rate.

These properties are spread across 48 states in the U.S., providing geographical diversification and more than $360 million in annual base rent.

Speaking of diversification, no more than 5% of their annualized base rent came from any single tenant.

In fact, just two tenants account for more than 2% of its annualized rent.

On top of that, long-term leases are another critical aspect of the company’s strategy.

Going into this year, the weighted average remaining lease term was 14.0 years. Additionally, the company utilizes master leases for 65.7% of its annualized base rents.

According to the company:

A master lease is a single lease pursuant to which multiple properties are leased to a single operator/tenant on a unitary (i.e., “all or none”) basis. The master lease structure spreads our investment risk across multiple properties, and we believe it reduces our exposure to operating and renewal risk at any one property, and promotes efficient asset management. – EPRT 2023 10-K

Speaking of smart leases, it’s time to talk about SLB transactions.

Going into this year, sale-leaseback leases accounted for 98.8% of the company’s annualized base rent, making it the biggest SLB REIT on my radar.

In the first quarter, the company invested roughly $250 million with a weighted average cash cap rate of 8.1%. It sold assets worth $12 million with an average cap rate in the 6% range, improving overall profitability.

Interestingly enough, 100% of its investments were sale-leaseback transactions. 87% of these transactions were made with existing tenants, with a weighted average lease term exceeding 17 years.

On top of that, it needs to be said that EPRT maintains a healthy balance sheet, which allows it to fund attractive SLB deals.

Our sale leaseback capital is particularly attractive as the continued dislocation in the credit and bank markets has contributed to tighter lending conditions. With quarter end pro forma leverage of 3.6 times and liquidity of over $850 million, our balance sheet positions us well to grow our portfolio by deploying into these tailwinds resulting in risk-adjusted returns for our shareholders. – EPRT Q1’24 Earnings Call

As discussed in the quote above, the company has a pro-forma leverage ratio of no more than 3.6x EBITDA and more than $860 million in liquidity. $600 million of this comes from unusual credit from its credit facility.

It has a BBB- investment-grade rating from Standard & Poor’s.

Dividend & Valuation

EPRT pays a quarterly dividend of $0.285 per share. This translates to a yield of 4.2%, protected by a 66% 2024E adjusted funds from operations (“AFFO”) payout ratio.

The five-year dividend CAGR is 11.9%.

Although I don’t expect dividend growth to average 11.9% in the next five years, we are looking at a very promising AFFO growth trajectory.

Using the FactSet data in the chart below, analysts expect the company to grow its per-share AFFO by 5% this year, potentially followed by 7% in 2025 and 6% in 2026.

This also bodes well for its valuation, as the company is trading at a blended P/AFFO ratio of 16.0x, roughly 2.5 points below its long-term valuation of 18.5x.

Theoretically speaking, EPRT has room to return north of 15% per year if it returns to an 18.5x multiple – including its 4.2% dividend yield.

While I do not expect that to happen unless interest rates come down substantially, the company offers tremendous long-term value, which I expect to turn into favorable long-term returns, even if the current environment is challenging.

Takeaway

Sale-leasebacks present a compelling opportunity in the commercial real estate sector.

With the potential to unlock significant value, SLBs offer a viable alternative to traditional financing methods, particularly in a high-rate environment.

That’s where EPRT comes in. Essential Properties Realty Trust has emerged as a standout player in the net lease industry, leveraging its focus on essential industries and smart lease structures to drive growth and shareholder value.

With a strong balance sheet, attractive growth opportunities, and elevated dividend yield, EPRT has the potential for sustainable long-term returns.

As SLB deals continue to gain traction, EPRT remains a top contender for investors seeking resilient income streams and capital appreciation in the dynamic real estate market.

Pros & Cons

Pros:

• Resilient Revenues: EPRT’s focus on essential industries provides a stable income stream, even during economic downturns.
• Smart Lease Structures: The company’s long-term leases and master lease strategy mitigate operational and renewal risks.
• Attractive Dividend Yield: EPRT pays a quarterly dividend with a solid yield of 4.2%, supported by a sustainable payout ratio.
• Strong Balance Sheet: With a pro-forma leverage ratio of 3.6x EBITDA and elevated liquidity, EPRT is well-positioned to capitalize on growth opportunities, including attractive SLB transactions.
• Attractive Valuation: EPRT trades at an attractive valuation, which could lead to above-average returns in the years ahead.

Cons:

• Dependency on Interest Rates: EPRT’s valuation and potential returns are influenced by interest rates, which could impact its ability to achieve long-term growth targets.
• Market Volatility: Like any real estate investment, EPRT is subject to market fluctuations and economic uncertainties, which may affect its share price in the short term.