Agree Realty Corporation (ADC) Earnings Call Transcript & Summary

Good morning, and welcome to the 10:30 a.m. session at Citi's Global Property CEO Conference. I'm Katy McConnell with Citi Research, and we're pleased to have with us Agree Realty. Before we get started, this session is for city investing clients only. So if media or any other individuals are on the line, please disconnect now. Disclosures are also available up on the webcast. [Operator Instructions] And now, Joey, I will turn it over to you to introduce your team and the company and provide some opening remarks, and then we'll go into Q&A.

Great. Thank you, Katy. I'm Joey Agree, President and CEO of Agree Realty Corporation; Peter Coughenour is our Chief Financial Officer. And then sitting in the second row over there is Craig Erlich, our Chief Operating Officer. Agree Realty, ticker symbol NYS -- ADC in the NYSE. We're a net lease REIT focused on the top retailers in the United States. Today, we're about a $6.5 billion enterprise value. Our largest tenants are really led by the largest retailers in the country. So Walmart being approximately 6.5% of revenues. Our balance sheet is really the strength and the core of this company. Peter can speak to that in more detail. I'm sure we'll get a couple of questions. Our focus is on leveraging our 3 external growth platforms: acquisitions, development and partner capital solutions to find the best risk-adjusted opportunities in the net lease space in the Continental United States. Today, our portfolio is just over 1,400 properties and growing again, led by Walmart with the largest retailers: Home Depot, Lowe's, Dollar General, T.J. Maxx, Tractor Supply, quickly following suit are O'Reilly Auto Parts, AutoZone. And our 3 external growth platforms are -- look to find the best risk-adjusted opportunities across the United States in those 3 different areas. And so we have development origins. We launched our acquisition platform in 2010, but we retain the capabilities with our retail partners to continue to grow the portfolio. And so our goal is to deliver strong double-digit total shareholder returns, upper single-digits AFFO growth, extremely well-covered dividend at approximately 75%, 74% of AFFO, again, led by our offensive line of balance sheet. Our initial acquisition guidance for the year is $1.1 billion to $1.3 billion. We come into the year with -- in really tremendous positioning with $520 million of forward equity as well as $300 million swap and forward starting swaps for an eventual 10-year unsecured offering at 1.7% as the base rate. And so we're in a tremendous position with a unique portfolio, 68% ground leases over 14% -- 68% investment grade, excuse me, over 14% ground lease portfolio to continue to grow this portfolio in a prudent, consistent and disciplined manner and find those opportunities that are going to drive that per share growth.

Great. Thank you. So to open each session, we're asking what are the top 3 reasons why investors should buy your stock today over any of the other publicly listed REITs?

Well, first, as I just mentioned, I think we've come into this year tremendously positioned with little to no capital needs to hit the midpoint of our acquisition guidance given the $520 million of forward equity, our new $1 billion revolving credit facility with minimal capital drawn from that facility. And of course, as I mentioned, the $300 million forward-starting swaps. So our capital needs, at least for the intermediate term, are well put to bed and taken care of; second, the underlying portfolio here, again, 67% investment grade, over 14% ground leases. The biggest and best retailers in this country has withstood not only the pandemic, but it's recession-resistant. And is focused on retailers that are, one, growing; and two, provide for necessity-based goods and services. We don't traffic in luxury retailers. We don't traffic at experiential or -- experiential retailers such as the movie theaters or any of the other activity-based retailers you see out there. And we don't go up the risk curve in terms of sale leasebacks for small or medium-sized enterprises. Lastly, I think our ground lease portfolio, which again is over 14% of ABR, approximately $50 million and NOI is extremely underappreciated today. That portfolio is 87% investment grade, 12 years weighted average lease term and is comprised of the best retailers in the country. Of course, if they were ever to leave, we had termination and a bankruptcy and a Chapter 11 or a failed to exercise an option, we get that building for free because they have spent the money and their capital to construct those facilities. So the ground lease portfolio provides a significant, we think, optionality going forward in the future and is a very unique attribute of the portfolio. All in all, those things continue to drive upper single-digit AFFO growth, 10% in 2021. That was on top of a 6% 2020 AFFO growth. So 2-year stack during the depths of the pandemic of 16% AFFO growth, which we think is extremely attractive on a risk-adjusted basis.

So my next question was going to be, what was the most -- what do you think is the most underappreciated growth opportunity within your portfolio? So it sounds like ground lease might be one of them. If you can expand on that a little bit more and how you plan to kind of prove out that value in hopes of narrowing your valuation gap today?

I think the ground lease portfolio is underappreciated and misunderstood. It really -- this portfolio was truly aggregated and developed and/or acquired really naturally through our traditional sourcing mechanisms. I would tell you, I think the biggest misunderstament -- or misunderstanding, excuse me, with this company, is we have been perceived as a defensive stock in a defensive portfolio with a defensive balance sheet. We weren't part of -- our tenants paid rent during COVID. We collected all of our rent. We weren't part of a reopening or a vaccine trade. And so I think the stability of the portfolio proved out there. And so to grow AFFO during the pandemic by 6%, to double investment volume of over $1.3 billion and then repeat that last year in 2021 and to guide to it again in 2022, I think that defensive nature, frankly, undermines the compounded AFFO growth that we continue to drive on a balance sheet that's levered 4 to 5x with no near-term debt maturities and no floating rate debt.

And how does the current macro environment with inflation and anticipated rising rates impact your ability to deliver on AFFO growth that you just outlined?

It truly doesn't. I'm not sure if we're still in a rising rate environment given the global macro situation that we're in today. Short-term rates, albeit but long-term rates, we'll see. I think the boon is again negative. And so we'll see what happens with U.S. 10-year benchmark rates. I think the macro environment and the volatility we've seen, we use -- and I mentioned on our last earnings call, we don't believe in just in time financing. And that's why we entered this year with over $800 million of effectively fixed cost capital outside of a spread on an unsecured issuance. And so our visibility into medium-term cost of capital enables us to execute on our pipeline across our 3 active programs: development, acquisitions, and PCS. And I think that's most important in a world that's seen in just 2 years now, a shutdown trade, a reopening trade, a reflation trade and now we'll see the Putin trade what happens here. I think that's most important. So we're going to stay consistent. We're going to stay disciplined. We're going to execute on our strategy and we're going to protect ourselves through any macro concerns or issues.

And coming out of COVID, what would you say are 1 to 2 things that have more permanently changed for your business? And how are you taking advantage of that, if possible?

So coming out of COVID, COVID reaffirmed our belief that, one, we're heading toward a world where all retailers are omni-channel. Brick-and-mortar is an integral part of that omnichannel overall experience. I'd encourage everybody to visit our website in the 3-dimensional landing page as well as some of the white papers we've issued. And then second, we believe that the biggest retailers are going to get bigger and stronger. I think we've seen it with Walmart's and Target's prints and Home Depot's prints. The biggest retailers in the world have the capability to, one, deal with rising labor costs; two, invest in price because you can't lose a customer as a retailer today because once you lose them, they don't come back; and then three, invest in macro and micro fulfillment, which nobody knows with the correct actual formula is going to be in the future. There's still a lot of experimentation. I think we saw last year -- or last week, which is Albertsons announcing strategic review of their businesses. Albertsons went public, they had surge sales. They had a balance sheet, got significantly repaired during the pandemic, right? They got the IPO. They still know they can't compete with Kroger and Walmart and Costco and Target's balance sheets and the investment necessary to thrive in an omnichannel world. I'll tell you -- Friday, myself and Craig were down in Bentonville, and we walked Walmart store 100 across in their headquarters, currently under construction. Their new micro fulfillment concept, which is bolted on to the store with automation currently under construction, which they've already issued in their press release and shown demonstrative videos of, every retailer in the country is going to have billions of dollars, national retailers, to experiment, to test and eventually effectuate a true omnichannel experience because you can't be an e-commerce-based retailer or just a brick-and-mortar-based retailer today, it doesn't work. And so I tell all investors, I think I said it in a couple of earnings calls ago. My children who are 9 and 10 years old now, in 10 years, they won't know if Amazon started online or Walmart started as a store because we're all heading to the same place.

And when you look at your tenant base, how many other Walmarts are there, would you say that are that advanced in terms of pursuing micro fulfillment within their stores?

Well, Walmart has a pretty unique strategy. I mean we have a white paper that really shows just the dichotomy between Walmart's micro fulfillment strategy and Kroger's Ocado-based macro fulfillment strategy. And so look, Target acquired Shipt. And so everyone is experimenting with different fulfillment capabilities. Best Buy is adding in-store lockers and using stores for macro fulfillment. In-store lockers being the exterior of the store and then using the stores to fulfill last mile. Every retailer loses money on the last mile. And until we truly have autonomous vehicles or drones, I'm still waiting for Jeff Bezos' drone to deliver something to my house in 60 minutes from, what, 8 years ago now. Until we have that last mile fulfillment in a rising labor cost and a rising energy cost environment is going to destroy retailer margins. And when you have a retailer such as Amazon that masquerades as a retailer and has no interest in actually making money in retail but just to satisfy and has AWS and advertising and other revenues to supplement that, and just really truly just wants data, they're going to continue to push the envelope. And so if you don't have the thought leadership and the balance sheet combined to compete, you're either growing or dying.

You published some reports on the rethink retail strategy. Maybe you could share some more thoughts on that and what advancements your retailers are making and how that's driving your leasing demand today?

Yes. In 2010, when we launched our acquisition platform, we said we were going to focus on e-commerce, recession-resistant retailers. I had a lot of people looked at us and said, e-commerce is only 1.5% of total sales. It's not a real threat. People like to shop in the store. Women want to try on clothes. Then it was Americans like to touch their produce and feel their groceries and all the different excuses we've heard all along. But we're going to a world very quickly where 25% of sales are e-commerce originated, whether they're picked up, they're delivered no matter what the modality is to actually service that to the customer is going to consistently be changing until we get to an efficient solution. In 2016 at another conference, I declared that e-commerce-based retail only without brick-and-mortar was dead to the gasps of the audience. And I said the only retailer in the country that makes money online is eBay. They have no inventory, they're third-party sales. And now we have now seen whether it's the Warby Parkers of the world or all the digitally native brands or Amazon with Whole Foods and now Amazon Fresh. Kohl's returns their physical part continuing to grow and grow and grow. We're seeing them all merge into the same case. And so what we've tried to do through both the website and the white papers provide macro-level analysis as well as micro analysis for our individual stores in our portfolio and how some of those retailers are responding and reacting to the conditions on the ground as accelerated by 5 to 10 years by the pandemic. And so we have a number of white papers on there. I encourage everybody to read them. They go from the Kroger and Ocado case, all the way to individual stores in our portfolio and what those retailers are doing to make the experience truly omnichannel and to reduce those last mile [ cost ].

I'm curious to hear your thoughts on just the outlook for consumer spending this year following such a strong 2021. Do you think that can keep up this year? And are you starting to see shifts between categories with goods and services?

To the last half, I'd tell you, we're probably not the best -- probably not the best person to tell you about shifts because all the retailers in our portfolio are all truly, really necessity-based. We're not -- they don't have luxury exposure. Many of them don't report sales per square foot. If you ask Walmart what that is, or a national retailer, they'll typically tell you to fly a kite. Do I think consumer spending will keep up with last year? Absolutely not. I think we saw a reopening trade with not only in the markets, but consumers wanting to get out and spend money. Now again, we have macro conditions. We'll see how those play out. Inflationary pressures. We'll see how those play out. But I think undoubtedly, we had consumers, I was one of them that was stuck in their house and all they were doing was buying furniture and home remodels. They couldn't travel. They weren't out there buying clothes. That's for sure. And so we're going to see different shifts and different patterns in that. I think we'll see less sales in the outdoor sporting goods, the guns, canoes, bikes that nobody -- everybody was out there buying during the pandemic for outdoor activities. I think we're going to see a shift. But the American consumer remains fairly fickle, and we'll see how they react to rising fuel prices and rising prices across the board with inflationary pressures.

You've talked about your focus on 20 to 25 tenants in the sandbox, primarily. Do you anticipate that this could grow with your acquisition pipeline this year? And maybe you could just discuss where you're seeing the most opportunities to that?

So we're constantly evaluating tenants that we think have the balance sheet and the thought leadership to effectuate their strategy in omnichannel world, Boot Barn being one of them. A few years ago, Boot Barn popped on our radar, if you follow them, publicly traded, BOOT is the symbol. It's a tremendous company. We came to the conclusion that anyone wants to try to sell boots online only, good luck, right? Order 4 pair, maybe keep 1. Boot Barn has done a tremendous job with not only their proprietary labels, but their merchandising and their store expansion. That's one that's been added. Gerber Collision was another. We looked very quickly at the collision space, we saw a number of private equity sponsored retailers that were operators that were in the collision space. But then we saw Gerber Collision who we started dialogue and who's based in Canada, publicly traded company, Boyd Group of Canada, 2x lease-adjusted leverage. As cars get more complex and more computers and more sensors and more cameras, the collision expense goes up, up, up. Gerber works directly with the large auto insurers to locate stores. We work directly with Gerber to help locate those stores and effectuate their store planning strategy. Those are 2 examples. That said, given the sales trends of the oddities that we talked that I just mentioned that we saw during the pandemic and then the reopening, it's very hard to get a true visibility into the retailers' predicaments and/or futures. And so we'll continuously monitor retailers. We'll remove tenants from that list if we don't like trends that we see. And then we'll add and make small investments in retailers that we think have the opportunity to become leading operators. Similarly, Sunbelt Rentals. We quickly saw rental -- the rental rate versus ownership rate in this country versus Western Europe, much more ownership here. Sunbelt Rentals is owned by Ashtead, the only publicly-traded investment-grade parent in the equipment rental space. And so we made a significant investment with Sunbelt Rental through a number of transactions and development. We'll continue to moderate. Nothing material really on the horizon though.

And are you starting to see more cap rate compression for the net lease assets that you are targeting in the acquisition pipeline? And what would be your outlook for the next 12 months in terms of where cap rates can go from here?

I wish I knew. I never predicted the 100 basis points of cap rate compression that we saw in the last 12 months. I mean it's just been truly astounding. For example, Tractor Supply's used to come out and trade around 6.75. We see them coming out. They've got an investment-grade credit rating, which has solidified their position. We've seen them come out at 5.25 and trade 5.25 to 5.5 today. Similarly, Dollar General, they used to trade between 6.75 and 7.15. We see them coming out of 5.25 and 5.5 today as well. So the cap rate conversion we've seen by no means did we anticipate it. I still -- it's still somewhat flabbergasting. In terms of a go-forward expectation. Look, this is a highly fragmented space. We'll do 300 transactions, 297 acquisitions alone last year on a granular basis. Average price point is $4 million to $5 million. We'll pick our spots and find opportunities. Projecting forward where cap rates are going to go, I'd have to get a crystal ball.

Okay. And then can you just update us on the opportunities across your 3 external growth platforms and what you're targeting in terms of investment spreads for each of those now?

Yes. So our initial guidance for acquisitions, we came out and said we had the strongest pipeline in the history of the company, coming into this year with initial guidance of $1.1 billion to $1.3 billion of acquisitions. On our most recent earnings call, we said we anticipate between our Partner Capital Solutions program and development, putting $50 million to $100 million in the ground this year that will range somewhere between, call it, 15 and 30 distinct projects. So again, fairly granular in nature, nothing overly large in there. But with the tenants that are currently in our sandbox, who approach us to help truly execute on their growth strategies. Acquisitions, we think we're going to be in the low 6s for the year, similar to where we've been historically for the last couple of years. Development PCS, we're generally looking for 100 to 250 basis point spread over market cap rates depending on the timing of the project, when it would come online and the overall relationship.

And on the development and PCS side of things, can you discuss why it makes sense to ramp investment a little bit this year within your guidance? And what are some examples of the tenants that are driving that development demand today?

It's truly opportunistic. We've had tenants, I won't name them yet today, but we had some tenants approach us who are having challenges executing on their growth strategies and/or high-priority relocations that can no longer rely upon their private developers who are subject to inflationary pressures. And we're privy to leases that they can no longer build around and would be out of money. And so we've had a couple of tenants as well as opportunistic additional projects that we source, approach us to get some stuff done for them. And so we anticipate in Q1, we'll have -- with Q1 earnings, we'll have a number of projects that we'll announce will become fairly visible who we're working with. We're subject to CA at this time. But we will -- it will be tenants that are currently in our sandbox that are growing. And we have tenants that are growing fairly voraciously in that sandbox. Now there are many tenants that are spending their capital not net new stores, but on fulfillment. But then there are a number of tenants in the portfolio that continue to grow pretty aggressively. That said, we will be very picky. We've been approached by a Dollar store who asked us to put 100 stores in the ground and develop for them. We have no interest in doing 100, 800 -- a 100, 800 $1 million projects spewn throughout the country that are effectively getting -- might as well get into the home building business if we're going to do that. That's not efficient for us and that's not something that we want to entertain. And so that doesn't really fit within our framework. But there are tenants out there that are having those challenges, and we have the solution for them.

Could you talk about some of the advances that your proprietary ARC program is making in your acquisition underwriting and portfolio management process?

Yes, I won't take any credit for it. [ ARC ] has been a tremendous tool. Craig and Peter have been at the forefront of ARC, and Peter designed the initial template in Excel in ARC. I'll let Peter hit on ARC and just its overall impact.

Yes. So we use ARC across the organization, acquisitions, asset management through various departments and throughout ADC. It's been a tremendous tool for the acquisitions team in identifying and underwriting opportunities more efficiently. And it also allows us to combine our portfolio data with our pipeline and to project out future concentrations for the company, and we can set thresholds of where we want a tenant or a sector to be in the system. And originators know how much capacity we have to add exposure to that specific tenant. And I think that's really powerful because not only are we gaining operational efficiencies, but we're identifying where our originator should spend their time and where they should not spend their time quite frankly.

Great. So maybe just shifting to the capital and funding side of things. We have a question online. Do you feel more comfortable debt financing acquisitions here given stock underperformance? And your comments on the attractiveness of lower yield ground leases.

One, I would -- just to be clear, we -- the ground leases that we've acquired are in the same strike zone as the net leases that we've acquired. We're acquiring assets traditionally between 5 and 7 bps. Now there are outliers, there are higher yield short-term deals where we'll do an early extension. But by no means will we extend ourselves to acquire ground leases. Like I said, it's been opportunistic. It will ebb and it will slow. The second half, Peter, you could take that.

Sure. I would just add, I think today, our stated leverage range is 4 to 5x net debt to EBITDA. If you look back at where we've operated historically, before the onset of the pandemic, we operated in a range of 5 to 6x. What's the right leverage range us to operate moving forward? We'll continue to evaluate. Obviously, given the quality of the portfolio, we think that it can support potentially higher leverage than our range today that we feel very comfortable operating within that range. But we're not going to change our financing strategy or, on a reactionary basis, change our leverage ratio simply given cost of capital on a spot basis.

So including your forward equity offering, pro forma leverage, I think, will be below 4x. So in the context of that, what is the right mix this year in terms of equity and debt funding?

Well, as Joey mentioned, we have $500 million, $520 million approximately of outstanding forward equity available to us as of year-end. We also have in place $300 million of forward-starting swaps, which contemplate a 10-year unsecured debt issuance. And thinking about that mix and the mix moving forward, I wouldn't anticipate any significant deviation from how we funded the business historically, which has been about 75% equity, 25% debt.

And I think you mentioned that at the beginning, but where do you anticipate you could raise the 10-year debt today?

It has been a choppy start to the year, especially in the investment-grade public unsecured markets, that's for sure. I think fortunately for us, given the outstanding forward equity, the swaps we have in place, we have the opportunity to be opportunistic in when we access the markets given the balance sheet position that we're in today. And it's tough to say exactly where we'll execute, but we'll pick the right spot based on uses and where the market's at.

Historically, we've been about approximately plus 100 basis points on a historic basis. The base rate swapped at 1 7 will obviously imply 2 7. We think we're on the cusp of an upgrade here hopefully in the near term from the rating agencies, although I think fixed income investors and our bank group like already view us as a BBB+ credit. We're Baa2 positive from Moody's today. And so we think we're in a great position. But by no means are we going to dive head first into this credit market.

And then on the equity side of things, how do you think about the trade-off between doing additional forwards this year versus overnight or ATM based on where the cost of capital environment is today?

That's somewhat of a misnomer, I probably should have brought that up on. People think we're only doing forwards. Out of the 3 equity offerings we did last year, only 1 was on forward. So we did 2 regular overnight offerings plus regular plus ATM activity. The composition of our equity capital needs will be based upon our existing pipeline. When we did the December deal, and by no means do I like December deals, in the pros that we disclosed, approximately $600 million in activity across all 3 platforms. And frankly, we weren't comfortable waiting until this year to fund it. We've already closed the first tranche of what we call the FDI portfolio and a significant number of investment activities quarter-to-date. In hindsight, it was, I think, the right decision to make, unless we went maybe the first couple of weeks of January. And so our pipeline will drive our capital needs. That said, we'll continue to drive for a medium-term visibility through the use of hedging and swaps. This is an external growth business just-in-time financing is just-in-time problems. We're not going to ever get to that point.

Great. So before we get into our rapid fire, one last question here. What is your #1 ESG priority for the company this year?

Mr. ESG?

So I'd start just by mentioning we've recently engaged with a third-party consultant to help on the ESG front. We're working with them to map out a 3-year action plan. That process is ongoing. As I think about our more immediate priority for ESG, I think it's to continue to engage with our retail tenants and relationships and partners that we have on the acquisition development and PCS front. And we're fortunate in that we work with national and super regional retailers that many of which are leaders in ESG. And we'll continue to have dialogue with them on green lease clauses and other initiatives, shared sustainability initiatives that we can achieve together.

Are you starting to see improvements in terms of what the retailers are reporting up to you from an ESG front from their own progress?

Well, I think -- like I mentioned, many of the retailers that we work with are public, are leaders in ESG and have their own ESG platforms and report a lot of that information themselves. We're continuing to have dialogue with them about what information they'll share with us. But the fortunate piece is a lot of that information is already out there for consumption.

Great. Okay. So we'll go into rapid fire now. What will same-store NOI growth be for your property sector overall in 2023?

1% net of credit loss.

Okay. What will the 10-year treasury yield be 1 year from today?

I'm going to go with [ 1 5 ].

Wow, that's a unique one.

The boon is negative today.

Okay. And will your property sector have more or fewer public companies a year from now?

Fewer.

Great. All right. Joey, Peter, thank you very much.

Thank you.

Thank you.