Introduction
Essential Properties Realty Trust (NYSE:EPRT) acquires and leases single-tenant properties to middle-market companies operating service-oriented or experience-based businesses. In many ways, EPRT is similar to their larger and better-known peers in the free standing retail space, such as Realty Income (O) and NNN REIT (NNN). Like the two, EPRT has an investment grade issuer rating with a stable outlook*. Unlike the two, EPRT does not have investment grade-rated tenants. EPRT also does not have a long operating history; they offered their shares to the public for the first time a little over five years ago.
In this article, we evaluate the business model of EPRT in some detail. When instructive, we distinguish EPRT’s business model with that of the more familiar REITs in the free standing retail subsector. We consider specific risks for their business and review management’s strategy in mitigating these risks. We then estimate how much value their business model creates by comparing their capitalization rate with their cost of capital. In quantifying the value created, we will form a view on the cost of equity and opine on whether the current stock price is trading at or at some distance to a measure of intrinsic value.
*S&P Global’s long-term issuer rating is as follows: Realty Income A-, NNN REIT BBB+ and Essential Properties Realty Trust BBB-. All three have a stable outlooks.
Investment Grade Tenants Vs. Non-Investment Grade Tenants
What is not often highlighted is that when a large, investment grade-rated REIT negotiates with a large investment grade-rated tenant, the REIT may not be coming from a place of strength for that particular transaction. Hypothetically, if the rated REIT were negotiating with a tenant of the caliber of a 7-Eleven, Sam’s Club or someone similar, the REIT would not have access to cheaper debt financing than the tenant. Furthermore, the REIT would also be disadvantaged because they are unable to derive a tax deduction benefit for interest expense as non-REITs do. Granted, REITs do not pay taxes at the corporate level, but as a direct comparison, REITs often have a cost of debt that is higher than their tenants. So, when a large, rated, triple-net lease REIT signs a sale and leaseback transaction with an investment grade-rated tenant, it is not because the tenant doesn’t have access to cheaper financing. It is because the tenant can redeploy the capital and earn a higher rate of return than what can be earned by buying the real estate in which their business sits in. Moreover, from tenant’s perspective, the commercial real estate market is active and well-developed. When the lease is up for renegotiation, the tenant is reasonably assured that there will be a variety of suppliers of real estate at competitive rates because of their strong credit.
EPRT’s business has a different dynamic. EPRT targets middle market operators that are underserved from a capital accessibility perspective. EPRT defines middle-market as “regional and national operators with between 10 and 250 locations and $20 million to $500 million in annual revenue”. If you are a middle market operator, such as a 10-unit car wash or an early education provider for a community, the chances are slim that you can access debt financing at a rate that is comparable to what investment grade debtors can get. The most likely source to finance real estate used for the business is a regional bank for which you would have to put a sizeable downpayment and secure a 15-year variable rate loan or some similar product. Therefore, when EPRT sits at the negotiating table with a potential tenant, their offering includes the benefits of a sale and leaseback which is enhanced by the fact that the potential tenant is limited in their ability to secure competitive financing on their own. EPRT is negotiating from a position of strength. In terms of dollars and cents, this translates to a higher capitalization rate than their peers that predominantly lease to investment grade tenants.
While EPRT can benefit from a higher capitalization rate, or cap rate, this is mitigated by the higher risk profile of their non-investment grade tenant base. EPRT manages this risk in different ways.
Source: EPRT 10-K for 2022
Tenant Risk Profile
EPRT property portfolio is diverse in terms of tenants, brands and geography. Please take a look at Table 1 for a sense of their current real estate portfolio diversity.
| Table 1: EPRT Portfolio Statistics (March 31st, 2023) | |
| Properties | 1,688 |
| Tenants | 348 |
| Concepts (brands) | 556 |
| States | 48 |
Source: EPRT 10-Q for Q1 2023
The three largest tenants had 112 properties and were responsible for 6.5% of annualized base rent (ABR). The top three concepts in their portfolio had 125 properties and were responsible for 6.9% of ABR. There is some concentration in terms of geography. Texas, Georgia, Florida, Ohio and Wisconsin were responsible for 37.9% of ABR.
There is meaningful concentration by industry. The top five industries accounted for 57.5% of ABR and occupied 66.5% of EPRT’s properties. The top five industries are: car washes, early childhood education, quick service restaurants, medical & dental providers, and automotive services.
As of Q1 2023, four of the 1,688 properties were vacant. 98.7% of ABR came from leases that obligate the tenant to provide periodic unit-level financial reporting and the weighted average rent coverage ratio was 3.9x for the quarter.
Because of their business model, 92.8% of ABR comes from service-oriented or experience-based businesses. There are inherent risks with this class of tenants. For one, these tenants are in industries that depend on discretionary spending and the lower the discretionary income, the lower the discretionary spending. As a counterpoint, there is a logic as to why EPRT targets tenants that are service-oriented and experience-based. Pre-Covid, the emphasis was on finding tenants that were insulated from e-commerce and tenants whose business models require real estate for sales and profit generation. Almost all of EPRT’s tenants fit this mold.
Another notable risk management strategy is that EPRT establishes rent that is at or below prevailing market rents. According to them, this enhances tenant retention and reduces releasing risk. Also, EPRT’s properties are “small-box” with an average investment per property of $2.4 million. The properties are fungible and appropriate for multiple commercial uses which also reduces releasing and obsolescence risk.
Let us now turn to how EPRT’s business model performs in practice.
Spread Investor
In economic theory, when a business can deploy assets and earn a return that exceeds the cost to acquire the assets then value is created. In the case of a REIT, value is created when the cap rate exceeds the cost of capital. The cap rate is the net operating income obtained from the assets and the cost of capital is the cost to use capital to purchase the assets for which income is generated. Fundamentally, EPRT is a spread investor. The wider the spread, the healthier the economic profit. Let us look at the spread in detail.
The first step in estimating the spread between the cap rate and the cost of capital is to review the cap rates for EPRT. Please take a look at Table 2 where we present the cash cap rates for EPRT and the implied cap rate for the NAREIT retail free standing for the last eight quarters.
| Table 2: Quarterly Cap Rates, 2Q’21 to 1Q’23 | ||
| EPRT Cash Cap Rates* | Nareit Free Standing Retail Implied Cap Rate | |
| 2Q’21 | 7.10% | 5.32% |
| 3Q’21 | 7.00% | 5.47% |
| 4Q’21 | 6.90% | 4.99% |
| 1Q’22 | 7.00% | 5.63% |
| 2Q’22 | 7.00% | 5.99% |
| 3Q’22 | 7.10% | 6.34% |
| 4Q’22 | 7.50% | 5.94% |
| 1Q’23 | 7.60% | 5.97% |
Source: Nareit T-tracker, EPRT 4Q’22 and 1Q’23 Supplemental Financial Information. EPRT defines cash cap rates as the annualized contractually specified cash base rent for the first full month after investment or disposition divided by the purchase or sale price, as applicable, for the property.
For EPRT, cap rates have been trending higher since the fourth quarter of 2021. There is no obvious pattern between the cash cap rates of EPRT and the implied cap rates for NAREIT free standing retail other than both saw the lowest cap rates in the fourth quarter of 2021 and that EPRT’s cap rates are higher for all periods presented. For our purposes, we shall use the cap rate of 7.60% as it is the most recent data available and indicative of the current economic environment.
Now that we have a sense of the cap rates for EPRT, let us now calculate the cost of capital. The cost of capital can be broken down into the cost of debt, the cost of equity and the relative weights of each form of capital in the capital structure. If a company has no debt, then there would be no cost of debt and the cost of capital would simply be the cost of equity.
Please take a look at Table 3 which presents the capital structure of EPRT.
| Table 3: Capital Structure | |
| EPRT | |
| Debt | 26.80% |
| Equity | 73.20% |
Source: EPRT Q1’23 Supplemental Financial Information
In Table 4, we present their outstanding debt and their weighted average interest rate which we shall use as a proxy for the cost of debt. As with the selection of cap rate earlier, the weighted average interest rate is from their latest filing and is reflective of current macro environment.
| Table 4: Debt and Cost of Debt Estimate | |
| EPRT | |
| Debt ($ in thousands) | 1,430,000 |
| Weighted Average Interest Rates | 4.90% |
Source: EPRT 10-Q for Q1 2023
In Table 5 we present an estimate of the cost of equity. There are different methods and philosophies around calculating the cost of equity. We shall use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the volatility of the particular stock.
| Table 5: Cost of Equity using CAPM | ||||
| β | 10-year Treasury | Equity risk premium | Cost of Equity | |
| EPRT | 0.86 | 3.86% | 4.50% | 7.73% |
Source: Beta and 10-year Treasury were from Seeking Alpha on July 12 2023.
The beta statistic measures the volatility with respect to the market. A beta statistic of less than one implies that the stock moves less than the market which is fairly common for REITs with stable cash flows. For example, EPRT’s leases had a weighted average lease term of 13.9 years which conceptually aligns with a lower beta statistic. The beta statistic only tells us how a stock is affected by systematic risks i.e., risks to the entire market. It does not consider the idiosyncratic risks touched on earlier.
I use the 10-year treasury as my risk-free rate and apply a spread, or an equity risk premium of 4.50%. The percentage used for an equity risk premium is somewhat subjective, though it is well within what many analysts would consider reasonable.
Now that we have a cost of debt, the cost of equity and the weights of each in the capital structure, we can calculate the weighted average cost of capital. Please take a look at Table 6.
| Table 6: Weighted Average Cost of Capital [WACC] | |
| EPRT | |
| Weight of debt | 26.80% |
| Cost of debt | 4.90% |
| Weight of equity | 73.20% |
| Cost of equity | 7.73% |
| WACC | 6.97% |
In Table 7, we quantify how much value is created by subtracting the cost of capital from the cap rate. After accounting for the current macroeconomic environment, volatility and opportunity cost, EPRT’s business model creates 63 basis points of value.
| Table 7: Value created as measured by Cap Rate – WACC | |
| EQRT | |
| Cap Rate | 7.60% |
| WACC | 6.97% |
| Cap Rate – WACC | 0.63% |
For context, I have applied this methodology in recent articles to other REITs in the free standing space. I have made different assumptions and adjustments so they are not directly comparable. Nevertheless, in my opinion, they depict accurately the value generating ability of the respective businesses and they put the 63 basis points in some frame of reference. Please take a look at Table 8.
| Table 8: Value Creating Comparison Among Selected REITs | |||||
| ADC | O | EPRT | NNN | SRC | |
| Cap Rate – WACC | 0.92% | 0.75% | 0.63% | 0.35% | 0.18% |
Source: My article on Realty Income and NNN REIT can be found here. My article on Agree Realty and Spirit Realty can be found here.
Creating value as business is only part of the picture. While it is necessary condition for a potential investment it isn’t a sufficient one. We also have to ask to whom does that value accrue to? Fixed income holders? Management? Equity investors? As equity investors with minority interests, we want to make sure that at least some of that value created shows up in our account.
To estimate if the stock is a worthwhile investment at the current price, we shall revisit our estimate of the cost of equity.
Cost of Equity Revisited
We estimated the cost of equity using the CAPM which is a statistical way of ascertaining the cost of equity. There are other methods to estimate the cost of equity. Also, cost of equity is the terminology used from the company’s perspective. It is the cost for them to obtain equity capital. From the investor’s point of view, the cost of equity is the required rate of return for an investment. And for many investors, particularly REIT investors, the required rate of return has two components: the current dividend yield and the growth rate of the dividends. Please take a look at Table 9 where we look at the total return as the current dividend yield plus the three-year compound annual dividend growth rate as supplied by Seeking Alpha.
| Table 9: Total Return | |
| EPRT | |
| Dividend Yield | 4.66% |
| Three Year CAGR | 6.52% |
| Total Return | 11.18% |
Source: Seeking Alpha on July 12, 2023
To quantify how much value is created for equity investors, the more relevant calculation is a comparison of the total return to the cost of equity calculated using CAPM. Please take a look at Table 10.
| Table 10 Relative Value | |
| EPRT | |
| Total Return | 11.18% |
| Cost of Equity (CAPM) | 7.73% |
| Difference | 3.45% |
After taking into account volatility, the capital structure and the current macro environment, EPRT’s stock offers compelling value above the cost of equity. Not explicitly considered in this analytical framework are the idiosyncratic risks we discussed earlier. Credit rating agencies do consider idiosyncratic risks when they issue a rating. Potential investors should contemplate whether the 3.45% differential is sufficient compensation for the idiosyncratic risk profile of EPRT.
Conclusion
EPRT has a compelling competitive advantage. By virtue of their investment grade issuer rating, they are able to access debt (and equity) markets competitively and acquire real estate assets efficiently. They have targeted a category of tenants that are underserved from a capital accessibility perspective which enhances their offering at the negotiating table. Their tenants have a higher risk profile that some other REITs, but management has sensible strategies to mitigate these risks.
The current spread between the cap rate and the cost of capital is adequate and the investor can access that spread at a meaningful discount as evidenced by the difference between the total return and the cost of equity. Prudent investors should consider building a position in the stock.
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