Phillips Edison & Company, Inc. (PECO) Earnings Call Transcript & Summary

Good morning, everyone. Welcome to Citi's 2024 Global Property CEO Conference. I'm Craig Mailman with Citi Research, and we're pleased to have with us Phillips Edison and CEO, Jeff Edison. This session is for Citi clients only. [Operator Instructions] Jeff will turn it over to you to introduce your company and team provide any opening remarks. Tell the audience the top reasons as an investor should buy your stock today, and then we can get into Q&A.

Great. Thank you for having us today. With me today is Kim Green, our Head of IR, Devin Murphy, the Head of our Asset Management team, Bob Myers, our President, and John Caulfield, our CFO. Again, thank you for being here today. As we enter this year and are looking at what the horizon looks like for PECO this year, I think we're in a very similar situation to what we've been talking about the end of last year, which is a really outstanding operating environment but a more difficult acquisition market. And if you look at PECO's core strategy, you see that we're based [indiscernible] is one of the key parts of our strategy is when 70% of your retailers are necessary goods, that gives you a different perspective on what the variability will be this year in the market. So we're optimistic about that part. I think we have pretty good visibility in the year and think that we're going to have another strong leasing year. And again, as we've talked about in the past, we've got tailwinds that continue to be very strong in our business, which is what's really driving a lot of the operating results. And it includes work from home. It includes suburbanization, includes transfer to the Sunbelt, all bringing more shoppers closer to our centers more of the day, which is obviously very positive on the demand side. And then on the supply side, there's very limited new development, and that has put us in a position where we're able to have market-leading occupancy, market-leading spreads. As we said, probably is a good operating environment as we've had. The one issue in the business is, as you know, we have a really strong internal engine that drives very strong same-center NOI growth. We also have an external program where we're really trying to drive acquisitions. And that's the part of the market that we feel less certain about going into this year and looking out through the end of the year. We continue to have more opportunities than we did last year at this time. So we're better than last year, but we're still not back to where we had been in the previous years. So we'll see what happens this year on the acquisition side. We continue to guide towards $200 million to $300 million of acquisitions. And we have set our balance sheet up so that we can do significantly more than that if the opportunity arises. So we're excited about what's going to happen this year, particularly on the operating side and then we'll see what happens on the acquisition side.

And maybe sticking with the acquisition story funding, right? How do you guys kind of weigh equity versus debt today as you kind of blend it into where you can buy?

When you're in an environment where you have interest rates moving dramatically, prices on equity moving, our target is to make sure that you're match funding your acquisitions with your total cost of capital. And that's how we approach it. That's how we approached it last year and actually the year before, giving us a long runway and a really strong balance sheet so that we can be opportunistic when the opportunities are there, but taking a relatively conservative position on the balance sheet.

I would say we're 5.1x levered and we have over $600 million of liquidity. And so when we look at our acquisition guidance of $200 million to $300 million, we feel very confident and comfortable with our ability to fund that. And as we look at it, as Jeff said, we're looking to be opportunistic. We're going to approach each market when it's in a favorable position versus what last year and the year before, the debt market was more in an unfavorable more volatile position. So we took an opportunity to over equitize. Well, now the debt markets are improving, and so we feel very confident in our ability to fund our plans.

Where do you think debt costs are for PECO right now as you look out and what are the near-term funding needs from just a maturity standpoint?

We have no meaningful maturities until November of 25. So we have a very long runway. In terms of a new debt cost, I would say, it's between 5.75% and 6%, which if you look at the acquisitions we made last year, the weighted average cap rate was at 6.6%. And so we do have an opportunity. But what we have is because we've worked to manage our maturities, we have the ability to be patient and flexible. So we're going to access the market when we feel that it is opportunistic.

And what's the just overarching thought process on issuing debt when it's if the market comes your way, you could still park cash in 5% to 5.5% interest-bearing accounts and having on hand, if you have a good pipeline of deals versus maybe trying to save on that 25 bps on of dilution because you don't have anything, so you're going to try to raise debt once the pipeline gets full or you run the line up. What's the throttle back and forth between the line usage versus locking in longer-term capital?

So our target is to, again, do this match funding. So we want to match fund the debt with longer duration like our properties are in longer duration. So that is, if there's a trigger event, that's what we're trying to make sure that we do match fund that. And again, it's being opportunistic with regard to where is the acquisition market? Where is our ability to place significant amounts more or less than our target in terms of that plant and then to make sure that we've got the right set of both equity and debt.

I would say I think the piece is that we're focused on just, as he said, match funding, but also, for us, we are active users are aligned because it ultimately allows us that flexibility. But we're $180 million drawn on an $800 million line with additional capacity. So definitely, I hear what you're saying you're watching to make sure that we're not put in a box on either the equity or the debt side, but it's going to be a function of, as Jeff said, if the acquisition opportunities are there, we're certainly interested in managing that liquidity and forecast.

And the visibility at this point in the $200 million, $300 million of acquisitions, what's in the pipeline? Are you close to putting anything under contract? What could the cadence be on that or is that still a fill for guidance at this point?

We have closed on one project that I think has been disclosed, Kim I hope that's, and I would say that we have a relatively okay backlog. But we've seen twice as many projects in our committee as we did last year at this time. So we are generally optimistic that the volume will be there. But again, the bid-ask continues to be challenging in an environment where there's uncertainty on interest rates and that some of our competitors for these acquisitions are basing.

So to stick on acquisitions, what has been the return environment? It feels like things have gotten a little bit better, at least from the commentary of the last quarter or so. I know for your assets in your markets, where have cap rates gone? Can you describe a little bit the competitive landscape or for the bidding pools at this point?

So last year, second and third quarter were probably the least amount of transactions that we've seen in 10 years. It was a really slow case. And there was really as large of a bid-ask discrepancy as we've seen in a long time. Today, it certainly has narrowed and as you know, we're not really a cap rate buyer, an IRR buyer, and we're really looking at where we can take the project over time. We continue to be focused on an unlevered or more. And we found that last year we underwrote over 9.5% in terms of the properties we bought, and we bought $275 million of net acquisitions last year. So I would say that we're optimistic we'll be able to do that. I think that will translate probably into somewhere between a 6.4% and 6.7% cap rate for necessity-based grocery-anchored shopping centers that are in that 115,000-square-foot category. The market has bifurcated in terms of power and grocery and bigger centers in smaller centers. So there are multiple things being laid over on the acquisition side to get to exactly what a cap rate is, but I'm really describing our business in terms of that necessity-based retail that's that 115,000 with a 50,000 to 60,000 square foot grocery in it sort of the corner [indiscernible] our house. That's the centers that we're buying and that's where they're trading.

And you guys are more necessity-based. At this point, kind of what's your current outlook for the health of the consumer and your demographics. People feel like at the lower end, they've been a little bit more pressed at the middle to higher end, people are generally in a little bit better shape, but consumer spending continues to chug along, defying expectations. So I'm just kind of curious, as you guys look at your exposure, what you're underwriting for kind of the health of tenant credit, the health of the consumer.

I would say that people have for a long time, understated the markets that we're in. Our median household income is well above the median household income for the country. It's also about the median household income for Publix and for Kroger, who are our 2 largest neighbors. We're Kroger's largest landlord, we're Publix's the second largest landlord. And we have over time been able to show the market the resiliency of necessity-based retail in the communities that we serve. And if you look at history a little bit and you step back and say, well, you guys are really vulnerable because you're serving the average American their necessity goods. And we're like, yes, we did, and we did it during the great financial crisis. We lost less than 2% of our occupancy, the lowest of any of the peers when everyone was saying, oh, your consumer is going to get smashed and get hit. So then you move forward 10 years, you hit the pandemic. Now we're going to show you guys how bad these markets that you're in are. And all of a sudden, we lose less than 1% of our occupancy, the lowest, and we're back to where we were the fastest of any of the peers. So we're going to continue to have this conversation with people over a long period of time. Our operating is we doesn't bear out the fact that there's any question in these markets. And our consumer is very healthy. Their employment drives a lot of the buying behavior of the average American, particularly their necessity goods because that's one area that I think people, they blend in. If you're a high-end discretionary merchant, you have a very different customer relationship in a recession than what we have. because people continue to buy their groceries, they continue to do their necessity goods no matter what the cycle is. And we just look at it and there's less beta in our properties than there is other properties where you may not buy some nice shoes or a new dress because you're cutting back, but you're going to cut back on those things well before you cut back on your groceries, your fitness, your medical, like those things were that we provide are the last on the list to be slowed down.

Only other thing I would add on that is the metrics tell the story. We have the highest occupancy in the space at 97.4%. Our in-line occupancy is at 94.7%. Our retention is at 94%. I think we ended up at 4.2 same-center NOI growth last year. So the demand is the best we've seen it in the space. You're going to continue to see strong retailer demand from fast casual, health and wellness services and med tail. And with our footprint owning the #1, #2 grocer at 115,000 feet, we have great visibility into the next 6 months, and the outlook is in line and very consistent with what we've done in the past. You look at our renewal spreads at 16.2%. That's leading the peer set. In addition, leasing spreads at 25.2% last year. So a very, very healthy environment for our type of product.

Getting credit has been an issue last year with Bed Bath & Beyond. Rite Aid cropped up, saw some news about JoAnn's over the weekend. What's your view of getting credit for the industry, but put that against your portfolio as you guys laid out initial guidance on what kind of expectations you have laid in there and what your view is just generally on the expectations of what could happen versus the cadence of things that have actually played out.

So we had 2 Bed Baths. And so when you look at our portfolio, we are highly diversified. Our largest non-grocer because that's where our concentration is, is the grocer, but our largest non-grocer are the T.J. Maxx brands at 1.3% of our ABR. And so ultimately, the focus and the strategy of Phillips Edison, which is we believe that format drives results is we have minimized our exposure to that secondary box. And if you look at, you mentioned JoAnn's, you've got Bed Bath, there's some other names there, they tend to be in that category. For us, outside the grocer, our spaces are 2,500 square feet, which have significant depth of demand. And so if you're looking at it from a credit perspective, our portfolio has had bad debt in the 60 to 80 basis points over a long period of time. Jeff mentioned our performance in 2 last major events. But as we look at it, we have a very resilient portfolio. Our neighbors are very strong, but it's really the diversification that comes with our footprint, and we believe our centers are differentiated in the markets they're in.

In the evolving Kroger, Albertsons situation, is that a net positive impact for your portfolio? Or what is the view there relative to maybe 6 to 12 months ago in terms of your exposure and footprint there?

So our view is it's a net positive if the transaction goes through. But it's important to note that the market is saying they don't think it's going through. The Albertson stock at a strike price is still trading at a 23%, 24% discount to where it would execute on a transaction. The FTC is going to fight it. They've filed the lawsuit. It was pretty certain early on that Kroger and Albertsons had adopted a strategy that if it did go to court, they were willing to do that. So I assume that we're going to have a legal battle. And the government doesn't win all the time in these. I think they've lost 6 cases in the last few years. And there's a lot of precedent in grocery merger. So my guess is this is going to be a bitter fight between the government and Kroger and Albertsons, but it's really a toss-up in terms of what happens. For us, if it does happen, we'll have a couple of centers probably go into the C&S Propco deal. We've estimated anywhere from 0 to 10. So we don't have a great handle on in terms of what that would be and only because Kroger doesn't know exactly what that's going to look like. But that part will be part of it. And then the other centers will become Kroger centers. And if they do, Kroger sales are better on a per store basis than what Safeway Albertson is. So we think that will be positive for our centers. They also tend to put more capital back into their stores, which, again, I think would be positive as well. So generally, yes, we think we'd like it to go through. We think it's good for the communities that we're in, and we think it's good for the stores. And if it doesn't happen, these were really strong Albertsons and Safeways that we had. And so we'll continue to operate that way. It will be uncertain because I think it's pretty brief. We have a fairly high level of confidence that a transaction or multiple transactions will happen because the ownership of Albertsons wants to get out. And if they do and though it's a public company, I think that will happen in some point.

Moving on to internal growth. Redevelopment has been a key for you and your peers. I guess you guys expect roughly about 100 basis points of contribution a year. Could you just walk through sort of the depth of this opportunity in the portfolio and any potential for this to increase over time the contribution?

I think there are 2 points. One, financially how we get there, like how do the numbers work and the other is what's happening on the ground in terms of retailers and where we're finding demand.

Sure.

So right now, we're giving guidance that our redevelopment development pipeline is between $40 million and $50 million a year. So we do have visibility out for the next 3 or 4 years on that. So I feel like we will be in that range for the next 2 or 3 years. The only other thing I'd mention about our development pipeline. These are smaller projects, typically $2 million or $3 million in size. Our yields were ranged anywhere from 9% to 12%. So smaller projects that you might find in your parking areas where you're going to build a 5,000 to 7,000, 8,000 square foot building. We've seen a lot of demand from Starbucks. I think we completed 6 Starbucks deals last year. Chipotle. We've done some Chick-fil-A deals. Drive-thru components are very important to those types of retailers. So we're going to continue to lean in with our national account team on building out that pipeline. But so far, it's been very positive with good returns.

The drive-thrus have been increasingly kind of relevant for a lot of end cap type tenants, Starbucks, fast casual, name them. We think 30,000 feet, but when you get down to the ground dealing with local municipalities, how are they reacting to the prospect of putting these in? How difficult is it with traffic patterns and ES and ingress into centers? Is there an appetite for it at the local level? Or are you guys feeling like there's a lot of pushback even if it could work at the center from a space perspective?

I'm not seeing a lot of pushback, honestly. The issue you hit right on the head, it's stacking. To put a Starbucks or Chipotle and/or McDonald's resorts, you have to have enough acreage to be able to do it, and the municipalities have been very favorable working with us on that. I think during COVID, we ended up putting drive-through windows on the majority of about 78, I believe, of our end caps because municipalities, they wanted businesses to thrive. They wanted retailers to continue to stay open and make money. So I feel like they're still in that mindset of growth.

And once you guys do the redevelopments, the 9% to 12% return is more of an immediate kind of benefit. But longer term, the value that you're creating at that overall center to be able to potentially curate with a new tenancy that would want to be near a Starbucks or what have you? What's the long-term benefit from just a value perspective across the different centers? I know it's a longer game because it takes 10 years to re-tenant, but just what you've seen so far on maybe some of these redevelopment dollars and that ability to recurate a center over time?

I think from a financial aspect, we believe that we can generate 75 to 125 basis points in same center NOI growth given the $40 million or $50 million that we're putting in.

More specifically on the projects we're talking about. When we were talking about an individual outparcel, that 9% to 12% is a cash-on-cash yield. And so ultimately, we're very happy to generate those kind of cash returns. But you're right, the actual cap rate of the individual outparcel is tighter than that. So there's absolute value creation there. But I think from our strategy standpoint, the biggest by far, traffic generator is the grocer. And so for us, making sure that we have a strong, healthy grocery, the right grocer in that market is even more important. Absolutely. We'd love to have the Starbucks. I don't know that I need to own the Starbucks, but I would like to have the Starbucks to do that. And it is positive, but the biggest generator is the grocer. But yes, we're talking 9 to 12 on a cash basis.

Great example real quick is that McDonald's, we saw McDonald's deal last year at a 3.5% cap. So there are some opportunities to step into some pretty attractive pricing on McDonald's and Chick-fil-As.

The only thing I would add there is when you're serving a community like each one of our 300 centers do, it's really critical that you have the right merchandising mix because that merchandising mix will drive the amount of traffic you have at the center and will allow you to be able to maximize rents over a sustained period of time. And things like a Starbucks, we're actually creating value the day they open the door, but they also add a longer-term value because people who shop at Starbucks also have other similar traits and the additional traffic that a Starbucks drives, drives more traffic to your small stores, which then allows you to have better small stores and brings the whole merchandising mix up. So there are a number of benefits of Chipotle and a Starbucks that they bring to your center, not just the traffic but also who is the traffic that's coming. And that's been a side benefit of our redevelopment and development plan.

And going to the other side of same-store occupancy, you guys have had nice high levels here. What's the confidence that you can continue to drive that higher? Where do you think it could ultimately top out what's the frictional point in the portfolio in your opinion?

So right now, we're at 97.4% occupancy, with in-line at 94.7%. We feel like we can move in-line occupancy another 100 to 150 basis points, so somewhere around 96 to 96.3. That's internally. On the acquisition side, we acquired 14 assets last year. 8 of them had some sort of redevelopment or development component. The average occupancy across all 14 assets was 87%. The assets that we closed about $185 million in the fourth quarter, we were at 84%. So we're going to continue to run a parallel path on finding some acquisitions that have some occupancy growth. So overall in the portfolio, but then internally, our in-line occupancy number, we feel like we can continue to move in another 100, 150 basis points . So upside in both areas for our portfolio.

And the leasing spreads you guys quoted were strong. I'm just curious, as we've talked about maybe remerchandising centers over time. How much of that is driven by bringing some new tenants in with the capacity to pay more, either a national franchise on the shop space or just your ability with top line inflation in the last couple of years that your existing tenancy can absorb this and pay these higher rents?

So when I look at the health of the consumer and our retailer, for our retailers, it's really occupancy costs. So right now, our average occupancy cost is around 9.4% for in-line tenants. We feel like we have room to move that up to 12%. So the retailers will not only stay healthy, but continue to make money. So there's some runway over the long term. And Obviously, we were at 94% retention with renewal spreads at 16.2%. And even as I have visibility out the next 6 months, I'm seeing numbers in line with that, if not better. So the health of the retailer is very positive in our shopping centers. And the demand is there.

And I think what we've seen over the last several years is that their sales are outpacing even the increases that we're getting. So it's creating that space there. So when it comes to merchandising mix, there's certainly elements there that you'll consider. But when you're as highly occupied as we are, you're pushing for cash. And so we believe that they're very healthy. And the economics are not the same. If you look at renewing a space at the renewal levels we're talking about versus retenanting, meaning you've got to put new capital in, you have downtime and then get going, we believe you would actually need a re-leasing spread above 50% to match that 16%, 17% that we're getting in place.

In that 250 basis points or so of occupancy cost uplift over time, what does that translate into a financial FFO or same-store and what's the time frame in years, maybe that it takes to close that gap as you churn the portfolio?

Look, we think that it can be 100 to 125 basis points. When we look at the mark-to-market, we believe that, as Bob said, as we look at our pipeline and what we can continue to drive, we believe we can be pushing this portfolio in the high teens and on top of that in terms of spreads. But it does take, we've got to wait for the lease roll. But we're also getting higher rent bumps than we've had historically. And so we're getting 2% to 3% escalators in addition to these renewal and new leasing spreads that we're generating. And so we think the path for growth is continuous. We went through some math at our Investment Community Day in December that walked through why we believe we can do it in addition. So we have real models, but then I did it using external information to prove that we can do this over a long period of time, generating between 3% and 4%.

And as you split out between the anchors and the shops, what's your success on the anchors getting some bumps through or getting some of these grocers to pay a little bit more, especially if you're targeting the top 1 or 2 grocers in the market, they clearly have a need to be there or desire to be there. What's the success rate on pushing things through to them?

So our grocers control their box for the next 30 years. And so ultimately, when you're talking about anchor for us, it is the grocer. And the most important thing for us is to have a healthy, strong grocer that's going to continue to deliver. There are opportunities that we have to renew them at very strong re-leasing spreads. But the most important thing as we look at it is their strength in terms of generating their sales volume, but really, it's generating the foot traffic in the center that allows our in-line neighbors to be successful. And then our rent growth is really coming from that in-line ABR. If you look at I think we have more than anyone else. I think we're at 55% or so of our rent comes from in-line ABR. And as we said, we think that's actually kind of the more alpha with less beta. Like the beta pieces is we have an investment-grade income stream in the grocer and our growth really comes from the in-line neighbor and their success.

As we think about operating costs and the trends there, insurance has come up a lot, kind of curious on the trends that you're seeing there, then shrinkage and security have also been a topic. Maybe those 2 aren't the biggest line items, but just walk through maybe what some of these headlines are translating into?

I think we're in an environment, particularly given the inflationary environment we've been in that insurance is going to continue to be a pretty big grower from a cost perspective. And fortunately, we pass 90-plus percent of that back to our neighbors. Unfortunately, though, it still puts pressure on them but we don't see that changing dramatically. And it's a combination of a lot of things. But primarily, the insurers desire to eliminate certain kinds of risks and concentrations. And as they look at that, it's a very simple thing to get out of markets and to raise rates. And then was the other question on the real estate taxes? Expense side?

I think you could hit on those, if you want to.

I think that's going to be something that we talk about more because a lot of municipalities need the cash. And one of the great sources of that is their real estate and the retail real estate in particular. So we think that there will be ongoing pressures there as well. All of that putting pressure on the retailers as we pass that through to them. And then eventually, that becomes a pressure on your ability to grow rents. But as Bob pointed, we're at 9% health ratio with our in-line neighbors. So when you look at that, that's a very healthy place to be for us. And we think there's room there to get from 9% to almost 12%, which gives us a lot of room to grow our rents.

Rapid fires real quick. Save starting for the group and 25.

Could you hear if it's the same store? For the group, 3%.

Property sector, more or less or fewer companies in 12 months.

Same.

And then best real estate decision: buy, sell, build, redevelop or repurchase stock.

Buy.

We did not waste any time. Thanks, everybody, for being here.