STORE Capital Corporation
Q4 2017 Earnings Call Transcript

Published: 22 Feb 2018

[Operator:]

Good afternoon and welcome to the STORE Capital Fourth Quarter and Full Year 2017 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that today’s event is being recorded. I would now like to turn the conference over to Moira Conlon, IR for STORE Capital. Please go ahead.

[Moira Conlon:]

Thank you, Andrea and thank you all for joining us today to discuss STORE Capital’s fourth quarter and full year 2017 financial results. This morning we issued our earnings release and quarterly investor presentation which includes supplemental information for today’s call. These documents are available in the Investor Relations section of our website at ir.storecapital.com under News & Results, Quarterly Results. I am here today with Chris Volk, President and Chief Executive Officer of STORE; Mary Fedewa, Chief Operating Officer and Cathy Long, Chief Financial Officer. On today’s call, management will provide prepared remarks and then we will open the call up to your questions. In order to maximize participation while keeping our call to 1 hour, we will be observing a two-question limit during the Q&A portion of the call. Participants can then re-enter the queue if you have follow-up questions. Before we begin, I would like to remind you that comments on today’s call will include forward-looking statements under the federal securities laws. Forward-looking statements are identified by words such as will be, intend, believe, expect, anticipate or other comparable words or phrases. Statements that are not historical facts such as statements about our expected acquisitions or our AFFO and AFFO per share guidance are also forward-looking statements. Our actual financial condition and results of operations may vary materially from those contemplated by such forward-looking statements. Discussion of the factors that could cause the actual results to differ materially from these forward-looking statements are contained in our SEC filings, including our reports on Form 10-K and 10-Q. With that, I would now like to turn the call over to Chris Volk. Chris, please go ahead.

[Chris Volk:]

Thanks so much, Moira and good morning everyone and welcome to STORE Capital’s fourth quarter 2017 earnings call. With me today are Mary Fedewa, our Chief Operating Officer and Cathy Long, our Chief Financial Officer. During 2017, we invested nearly $1.4 billion in acquisitions, including more than $360 million in fourth quarter alone. At the same time, we profitably divested approximately $250 million in real estate investments with more than half of that happening actually in the second quarter. Combined, our net investment activity for the year exceeded our net investment guidance of $900 million by over 25%. Our year-to-date investments and property sales reflect our ability to consistently invest in and divest of assets in ways that are accretive to our shareholders. At the same time, our portfolio remains healthy with nearly 75% of the net lease contracts rated investment grade in quality based upon our STORE’s core methodology in just 8 vacant properties at the end of the year. You will hear more about our property investment and sales activity and portfolio help from Mary. Our dividend payout ratio for the quarter approximated 72% of our adjusted funds from operations serving to provide our shareholders with a well protected dividend, a company that’s well-positioned for long-term internal growth based upon anticipated tenant rent increases and the reinvestment of our surplus cash flows. Our payout ratio was down from 76% in the third quarter, where we raised the dividend almost 7% and so it was on track to more closely approximate 70% over full year based upon our guidance. Now as I do each quarter, here are some statistics that are relevant to the fourth quarter acquisition activity that we did. Our weighted average lease rate this quarter was approximately 7.89%, up slightly compared to 7.85% last quarter. The average annual contractual lease escalation for investments made during the quarter approximated 2% providing us with a growth rate of return which you get by adding the lease escalations to the initial lease rate that was slightly increased from last quarter. Adding the initial lease rate to the contractual lease escalations resulted in un-leveraged growth rate of return of almost 9.9%. The weighted average primary lease term of our new investments continues to be long at approximately 18 years. The median new tenant Moody’s RiskCalc credit rating profile was Ba1. The median post-overhead unit level fixed charge coverage ratio for assets purchased during the quarter was 2.1 to 1. The median new investment contract rating or STORE Score for investments made during the quarter were favorable at Baa1. Our average new investment was made at approximately 82% of the replacement cost, 75% of the net lease investments made during the quarter were subject to master leases. And all of 110 of the new assets we acquired during the quarter are acquired to deliver as unit-level financial statements, giving us required unit-level financial reporting from 97% of the properties within our portfolio which is truly unprecedented. Our investment activity continue to be highly granular with 47 separate transactions completed at an average transaction size of just $7 million. At the end of the year the proportion of revenues realized from our top 10 customers was 18.5% of annualized rents and interest and that was up slightly from 16.7% at the end of 2016. And further our top 10 customers continued to be highly diverse and the largest single customer represented just 3.4% of our annualized rents and interest. And finally during the quarter we sold 15 properties, which represented an original acquisition cost of about $44 million which in combination with property sales earlier in year net of the gain over original cost of $13 million. Mary will dive deeper into this number for you, but our ability to generate profits from asset sales owes itself to our direct origination strategy. And as I have long stated, portfolio management activities like this which produced real economic gains served us to offset sporadic vacancies or assets underperformance which is a customary part of the net lease business. And with that I will turn the call over Mary.

[Mary Fedewa:]

Thank you, Chris. Good morning everyone. 2017 was another solid year for acquisitions with originations up over 12% versus 2016 and continued strong portfolio performance. In the fourth quarter we funded over $360 million of acquisitions at a cap rate of 7.9%. For the year we funded nearly $1.4 billion of acquisitions at a cap rate of 7.8%. We sold $254 million bringing our net acquisition volume to $1.1 billion ahead of our 2017 target of $900 million net of dispositions. Active portfolio management has enabled us to minimize portfolio investment risk and throughout 2017 we continued to sell certain properties. We sold 55 properties in 2017 at an aggregate gain over cost of around $13 million or about 5%. 25% of the properties sold were opportunistic sales and delivered the bulk of the gains averaging a 21% profit over cost. We were also able to make money on the 18 properties we sold for strategic reasons to reposition the portfolios, that gain was 8% over cost. These gains were slightly offset by the remaining 23 properties that were sold as part of our ongoing property management activities which resulted in an impressive 91% recovery. Now turning to some portfolio performance highlights, as of year end 2017, the service sector accounted for about 67% of our portfolio, less than 18% was an experiential retail and about 15% within manufacturing. Customer ranking within our top 10 remains unchanged from last quarter with our largest customer representing just 3.4% of annualized base rents and interest. Our portfolio continues to be highly granular and well diversified. Delinquencies and vacancies remained very low due to our active portfolio management and strong tenant partnership. As we ended the year only eight properties of nearly 2,000 property locations in our portfolio are vacant. And now, turning to our target market and our pipeline, our target market is the U.S. middle market which is generally defined as companies having between $10 million and $1 billion in annual revenues, this market consists of approximately 200,000 companies. The average middle market company has annual revenues slightly exceeding $50 million. Our average customer has approximately $800 million in annual revenues. Between 2011 and 2017 middle market companies represented more than half of the job creation in the U.S. and currently account for about 48 million employees representing over one in four workers in the U.S. We estimate that our tenants employed 1.8 million workers and have added approximately 180,000 employees to their workforces as they grew their revenues in 2017 approximately 10%. Such revenue growth is nearly 30% more than the middle market as a whole and about 40% more than the growth rate realized by the S&P 500 for the past 12 months. As a result of such a large and dynamic target market, our acquisition pipeline has grown by approximately 40% compared to year end 2016. Finally, I wanted to mention that we recently hosted our second annual customer conference, the Inside Track Forum in Scottsdale at the end of January. At this conference, our customers enjoyed a full day of presentations from a leading economist, a futurist, a capital markets panel, ASU business professors and a keynote address from Shark Tank star, Daymond John. Our goal is to continue to provide resources to our customers that can help them grow their businesses. STORE University, which is a series of business lessons posted on our website, is another example of how we add value to our customers. With that, I will turn the call to Cathy to talk about financial results.

[Cathy Long:]

Thank you, Mary. I will start by discussing our capital markets activity and balance sheet followed by our financial performance for the fourth quarter and year ended December 31, 2017. Then I will review our guidance for 2018. Please note that all comparisons are year-over-year unless otherwise noted. From a capital markets perspective, 2017 was an active year for STORE. Over the course of the year, we raised net equity proceeds aggregating $743 million from the sale of approximately 34 million shares of our common stock. This included the $377 million investment by Berkshire Hathaway in June, our follow-on stock offering in the first quarter and the sale of 5.75 million shares under our ATM program at an average price of $25.63 per share. Our ATM program has been a very efficient and effective way to raise equity and makes a lot of sense for us given the flow of our business and the size of our transactions. During the first quarter, we added $235 million of new, secured and unsecured long-term debt. This included a $100 million unsecured bank term loan at an effective rate of 2.57% with a 2-year term and 3 1-year extension options. We also sold 135 million of A+ rated 10-year net lease mortgage notes under our STORE Master Funding secured debt program at an interest rate of 4.32%. Then during the third quarter, we prepaid without penalty our Series 2012-1 Class A Master Funding notes, which had a principal balance of just under $200 million and a scheduled maturity of August 2019. These notes carried an interest rate of 5.77% and by paying them off early we reduced the weighted average interest rate of our long-term debt by about 11 basis points. As a result of these capital markets activities at December 31, our long-term debt stood at $2.3 billion with a weighted average interest rate of just under 4.4% and a weighted average maturity of 6 years. In an environment of rising interest rates, it’s important to note that all of our long-term borrowings are fixed rate and our debt maturities are intentionally well laddered. Our median annual debt maturity is approximately $250 million and we have no meaningful near-term debt maturities until the year 2020. Subsequent to year end on February 9, we expanded our unsecured revolving credit facility from $500 million to $600 million and expanded the accordion feature from $300 million to $800 million. This allows us to increase the maximum borrowing capacity under the facility up to $1.4 billion. The amended facility matures in February 2022 and includes two 6-month extension options. At year end, gross investments in our real estate portfolio totaled $6.2 billion, of which approximately $2.9 billion has been pledged as collateral for our secured debt and the remaining $3.3 billion was unencumbered. Our unencumbered assets increased to 53% of our portfolio in 2017, up from 43% in 2016. Longer term, we are targeting an unencumbered asset ratio of approximately 65%. Our leverage ratio at the end of 2017 was 5.7 times net debt to EBITDA on a run-rate basis. This equates to around 42% on a net debt to cost basis heading into the New Year with the closing of our expanded credit facility earlier this month. We had borrowing capacity of $310 million in addition to the $43 million of cash on our balance sheet. As I indicated earlier, the accordion feature of our expanded credit facility provides access to even more liquidity. In summary, we are well-positioned with substantial financing flexibility, conservative leverage and access to a variety of attractive equity and debt options to fund a large pipeline of investment opportunities. Now, turning to our financial performance, acquisition activity during the fourth quarter was funded by cash on hand net borrowings of $208 million on our credit facility and cash proceeds of approximately $44 million from fourth quarter asset dispositions. As of December 31, our real estate portfolio stood at over $6.2 billion representing 1,921 properties. This compares to $5.1 billion representing 1,660 properties at the end of December 2016. The annualized base rent and interest generated by our portfolio in place at December 31 increased 20% to $501 million as compared to $419 million a year ago. Acquisition activity drives revenue growth and in the fourth quarter revenues increased 18% year-over-year to $120 million. Total revenues for the year were $453 million, an increase of 20% over 2016 revenues. Our 2017 acquisition volume was spread throughout the year. Therefore, the full year revenue impact of that volume will be realized in 2018. Our consistently strong revenue growth reflects the broad-based demand for our real estate capital solutions. For the fourth quarter, total expenses increased 12% to $83 million compared to $74 million a year ago. Nearly 80% of this increase is due to higher depreciation and amortization reflecting the growth of the portfolio. For the full year 2017, total expenses increased to $330 million compared to $266 million last year. Again, this was due to the growth of the portfolio and much of this increase was related to higher depreciation and amortization expense. For the fourth quarter, interest expense was relatively flat compared to a year ago. Interest expense for the full year 2017 included a $2 million non-cash charge related to accelerated amortization of deferred financing costs associated with the STORE Master Funding notes we prepaid in August. Excluding this charge, our interest expense increased about 13% over the prior year as we continued to finance a portion of our acquisition activity with attractively priced long-term fixed rate debt. This increase was partially offset by a decrease in the weighted average interest rate on our long-term debt. Property costs were $1.5 million for the fourth quarter and $5 million for the year. The year-over-year increase was primarily related to property taxes, insurance and maintenance costs on properties that were vacant during a portion of 2017 as well as properties where we determined that our tenant was unlikely to pay those obligations. Property costs can vary quarter-to-quarter, but since 98% of our real estate investments are subject to triple net leases, property level costs are the responsibility of our tenants and therefore are not a significant portion of our annual expenses. G&A expenses in the fourth quarter were $11.2 million compared to $8.7 million a year ago. For the year, G&A expenses increased to $41 million and $34 million primarily due to the growth of our portfolio and related staff additions. For 2017, G&A expenses expressed as a percentage of average portfolio assets decreased to approximately 72 basis points from approximately 75 basis points during 2016 reflecting the scale efficiencies that come with portfolio growth. Net income increased to $41 million for the quarter or $0.21 per basic and diluted share compared to $32 million or $0.20 per share a year ago. Net income for the fourth quarter of 2017 includes an aggregate net gain of $3.8 million from property sales. This is consistent with an aggregate net gain of $3.7 million from property sales in the fourth quarter of 2016. For the year, net income was $162 million or $0.90 per basic and diluted share compared to $123 million or $0.82 per basic and diluted share for 2016. We had an aggregate net gain of $39.6 million from the sale of 55 properties in 2017. This compares to a net gain of $13.2 million from the sale of 31 properties in 2016. Net income for 2017 includes an impairment charge of $13.4 million primarily related to two properties that became vacant during the year. For the quarter, AFFO increased 22% to $82 million or $0.43 per basic and diluted share from $67 million or $0.43 per basic and diluted share last year. For the year, AFFO increased 24% to $306 million or $1.71 per basic and diluted share compared to AFFO of $246 million or $1.65 per basic and $1.64 per diluted share in 2017. Our dividend is an important component of our overall stockholder return and for the fourth quarter, we declared a quarterly cash dividend of $0.31 per common share. For the year, we declared dividends totaling $1.20 per common share, which included a 6.9% dividend increase in the third quarter. Since our IPO in 2014, we have increased our dividends per share by 24% while maintaining a low dividend payout ratio and at the same time reducing our leverage. Now, turning to our guidance, we are affirming our 2018 guidance first announced last November. Based on projected net acquisition volume for 2018 of approximately $900 million, we expect AFFO per share to be in the range of $1.78 to $1.84. AFFO per share in any period is always sensitive to the timing of acquisitions during that period as well as the amount and timing of dispositions and capital markets activities. In 2018, we expect acquisitions to be spread throughout the year that are often weighted towards the end of each quarter. The midpoint of our AFFO guidance is based on the weighted average cap rate on new acquisitions of 7.75% and target leverage in the range of 5.5 times to 6 times run-rate net debt to EBITDA. Our AFFO per share guidance for 2018 equates to anticipated net income excluding gains or losses on property sales of $0.82 to $0.86 per share plus $0.88 to $0.90 per share of expected real estate depreciation and amortization, plus approximately $0.08 per share related to items such as straight line rents, equity compensation and deferred financing cost amortization. And now, I will turn the call back to Chris.

[Chris Volk:]

Thanks so much, Cathy. As is usual for me to do and before turning the call over to the operator for questions, I’d like to make a few added comments. So first of all, we are really proud of our performance evaluating a company like STORE, which has so little performance volatility and it’s highly predictable in the near-term is best on over a much longer timeframe. So since we took STORE public with AFFO of $1.39 per share in 2014 we have increased this amount by 23%. At the same time, we also raised annual dividends per share that we paid out to shareholders by a sector leading 20%. That means we maintained a low dividend payout ratio to AFFO of roughly 70%. While the multiple we trade at has had some volatility over the last 3 years, it’s tended to center on the multiple we went public at in 2014 meaning that our dividend yield at the conclusion of each year has not been far for approximately 5% at which we introduced STORE to the public market shareholders in 2014. This overall annual stability has meant that our shareholder returns have deviated little on an annual basis at 12.6% in 2015, 11% in 2016 and 10.7% last year in 2017. In fact, our compound annual rate of return over these 3 years is at 11.4% is right on top of the performance for the S&P 500 and more than doubled to 5.4% compound annual rate of return of the MSCI REIT index. Over the same period, we have more than doubled the size of our balance sheet, more than tripled our unencumbered assets meaningfully lowered our financial leverage, maintained our sector leading investment and portfolio diversity and added to our A plus capital access through our master funding conduit by having now BBB and Baa2 ratings with stable outlooks from all three major credit rating agencies. As a result of our efforts, STORE today is bigger, more diverse and financially amongst the strongest in the net lease sector. Moreover with sector leading growth rates of return and investment spreads to our cost of borrowings, we have continued to grow our shareholder value in excess of its actual cost creating material and sector leading compound growth in market value added. Now, I mentioned all of this to take some stock in our accomplishments, but also because we have accomplished all of this without trading at the highest multiples in the net lease space and we are generally trading at below the aggregate multiples of the MSCI REIT index. I believe that our track record over the past 3 years like our leadership of prior successful net lease real estate investment trust over the past 20 years illustrates that this valuation gap was and is unwarranted, but more than this, the net lease sector on its own ranks near the bottom of real estate sectors today with few sector companies trading at multiples that even equate to the broader RMV average. I believe the net lease sector deserves better. Interest rate sensitivity today is the primary concern of investors with the frequent notion that net lease REITs have to be more interest rate sensitive in other sectors as a result of our comparatively long lease terms. And of course STORE’s are amongst the longest in our sector averaging 14 years, but we are not a long dated bond, we are a dynamic operating business having sector leading rental increases together with amongst the sector’s most protected dividends to arrive at a high level of embedded internal growth of today approximately it’s two-thirds or more of our expected AFFO growth for 2018. But addressing growth issues is just part of interest rate sensitivity. We are also over 40% leveraged as a percentage of the investment cost with no material debt maturities until 2020 and with laddered debt maturities on an annual basis that are not projected to be much more than our free cash flows most years. That means that our liability sensitivity or interest rate sensitivity on the maturation of our liabilities will likely range from a mere 1% to less than 2% of our total assets on an annual basis. In other words, the 10-year treasuries arrives at 4% and have little impact on our future cash flows from our investment portfolio and more importantly we have intentionally built STORE with leases having gross rates of return that are not far from those we had more than a decade ago in a prior company we led and in the materially different interest rate environment. With base lease rates close to 8% and lease escalators averaging about 1.8%, the gross unleveraged returns have been in the area of 9.6%. From 2003 to 2007 with average 10-year treasuries in the area of 4.4%, our lease rates averaged 8.6% with escalators of about 1.6% for gross unleveraged rate of return just 40 basis points higher than what we are today. And I should mention that this prior net lease platform delivered a compound annual shareholder return between 2003 and 2007 of nearly 20% in an environment where the 10-year treasury was 4.4%. By the way, our very first net lease investment platform was public from 1994 to 2001 where our 10-year tenure treasuries were averaging 6.2%. That company produced investor rate of return of 12.2% compounded or almost double that of government securities and that works in just about any investment market model. We also were able to surpass the S&P 500 with regularity. I am mentioning all of this to attempt to dispel the notion that longer lease terms equate to elevated levels of interest rate risk. This is a prevalent cognitive bias and it’s mathematically not so. After what changing interest rates might do to impact our external growth, we can expect elevated rates of company’s higher investment lease rates. Based upon our history of more than 30 years, while this relationship does exist and correlation is positive, it is nowhere near perfect. And I believe the word imperfection could also apply to other real estate sectors. So, my conclusion is simply that interest rates adversely impact all corporate valuations. As I remember Warren Buffet once saying, elevated interest rates are like gravity for the stock market. The discounted cash flow potential from all businesses just becomes worth less, here a well constructed net lease company should not be impacted anymore than any other well constructed corporation, which gets me back to the thought that based upon our performance and based upon our construct, there is no reason why we should not trade at the very least of the multiple equivalent to the overall REIT index that we have shown a long-term ability to exceed. Now, the net lease business itself is truly amazing. And I am saying this from the perspective of former commercial banker. The profits on our lease contracts that we create are highly senior and allow us to have contracts that exceed the applied credit quality of our tenants, whereas banks are happy just to be paid, we are happy to be paid more next year, whereas bank loan portfolios are less liquid is seldom worth more than par, we have shown an ability to regularly sell assets at material gains over our cost and whereas non-performing loans for banks can result in material losses, our investments are backed by hard assets and our average recovery is based upon resolved credit events is averaged 70% inclusive of administrative costs. So with this thought in mind, we are starting to at least annually produce an integrated lifecycle analysis in our appendix of our presentation. There you are going to see the average annual credit loss and resolved tenant issues, has been 20 basis points since we started STORE. We have offset this 20 basis point annual loss by about half through the profitable sale of real estate. At any given time, we also have what I would call work in process, which is underperforming real estate is in the process of being administered. Over many years in this business, we have generally tended to average 6 months or so to administer to underperforming assets. And I mentioned this, because this amount is not illustrated on the chart in the appendix or it could add another 40 basis points or so basis points to our average AFFO drag since we started STORE. So then you take the total drag and compare it to our un-leveraged internal growth which we expect to approximately 3.6% annually and you still have a number that’s more than 3% a year. The reason for the long view when looking at our business cycle is tenant performance is volatile. One of the reasons that we top out larger exposures of just around 3% of rent is to construct a portfolio that’s always capable of internal growth even we have an issue with the larger tenant as we did with Gander Mountain in 2017. STORE is by design a defensive company and would take a lot for us not to have revenue growth in any 1 year. And so with these comments, I am joined by – our group here is joined by Christopher Volk and Michael Bennett as well. And I am going to turn the call over to the operator for questions.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Vikram Malhotra of Morgan Stanley. Please go ahead.

[Vikram Malhotra:]

Thank you. Just wanted to follow-up sort of on your comments regarding sort of the net lease sector and the ability to grow, wanted to sort of get your view or thoughts on what would make you deviate dramatically downward from the acquisition base that you have been doing recently and vice versa are there – is there something that you would say would make you go the other way where maybe there are large portfolios, maybe there is other factors, can you just sort of talk about the tales?

[Chris Volk:]

I am sure I will start and Mary can probably add on these comments and good morning. I would say that first of all we tend to stay away from large portfolio transactions, so historically we stayed away from that. Today, we are trading at roughly a 13x AFFO multiple which is sort of silly because that means we are trading at a discount for net asset value. So 13x AFFO multiple by the way equates to our cap rate around 7.2%. And so the good news for us is we are able to buy assets at a discount to NAV, so we are buying assets at 775, 780, 790, so that’s the good news. But in terms of where we could sell the assets and where they would be worth it will be worth better than 7.2%. So where we are trading today is almost like a bank is trading less than book, which makes absolutely zero sense to us. My guess is over the long-term that we will be more in a range that’s been in the median. If you look at the REIT as a whole from an FFO yield perspective, the spread today is a record 6-year spread between REIT FFO yields and government securities, so that implies that perhaps there is a decoupling of where our REITs trade and where our government securities trade. So if you assume all of that and you look at like the long-term running AFFO or FFO multiples of REITs over the last – net lease REITs over the last 10 years or 15 years you get to sort of around 15x kind of median multiple in lots of different interest rate environments by the way. So I think that long-term that’s where we will be. Long-term, I mean in the near-term if we are trading at I mean 12x or 11x AFFO I guess will slowdown acquisitions, I mean our ability to make accretive acquisitions is probably better than anybody in the space just due to how we originate. We may have to start managing money for other people. I mean in the private market just might be more efficient than you guys and if that’s the signal that that get sent to us there are other ways that we can deploy capital. And I mean we started this company with Oaktree Capital and Howard Marks and Bruce Karsh and we can find other people to give us capital on a private basis. So, that’s where we have to go. I am expecting that won’t happen. I think it makes no sense that a private market is not liquid and not diverse would somehow trade at a better valuation in the marketplace, where it is liquid and is diverse and is BBB rated and does have access to different and more efficient cost of capital, but that’s not for me to say, I mean it can be driven by the marketplace. What I know is that we have options, we have created a huge platform here with the best acquisitions group in the business and it is choosing value as an operating platform and sometimes people think of these companies as a conglomeration of assets, but you really have to think about companies as ongoing operating businesses, I mean, this is a basically a financial services company by any other means, because we are providing real help to people who need it on their capital stack. I mean today, if you are in the middle-market America, there is virtually no good long-term financing to real estate, I mean, we can’t get it. It just doesn’t exist and there is no assignable debt, there is not pre-payable debt, debt is very difficult to modify. So, the solutions we are getting people are such that they would much rather have a landlord than a banker and we are giving them basically we are replacing both their debt and equity needs. And so we are fulfilling a very huge need and the business of these companies unless Mary said our companies have 1.8 million employees. So, from a stakeholder perspective, we are gratified to fill a need for these customers and we are going to find some ways to do that no matter what.

[Vikram Malhotra:]

Okay, that’s helpful, Chris. And then just quick question related to Gander, maybe just sort of give us the final update there in terms of dealing with the Gander sort of what the outcomes were and given your comments if I remember last maybe to the prior call, where you sort of said if there is one thing you would go back and redo, you saw the Gander coverages turning down and you want to get ahead – you would like to have gotten ahead of them. And are there any other subsectors maybe specific tenants where there are no red flags right now what you have seen saw deterioration you might start considering of potentially disposing some?

[Chris Volk:]

There are always some assets like that Vikram and we have done that over the years. I mean we just didn’t kind of we had I think a little bit more optimism on Gander than we should have had and so in retrospect we know we should have done differently and so it’s a lesson for us. In terms of the recovery, I think on the last earnings call we estimate recovery will be between 50% and 70% and it’s really a function of what we hold or don’t hold it. So if we don’t hold the assets which we may not do that, then the recovery goes up, because we are looking for some other profit and redeploy the capital. So, we will see exactly what we do with Gander that today at the end of the year, there were technically 4 vacant of the 8 properties that were on our sheet is vacant, 4 of them are Gander’s, but 2 of those were in CMBS and we noted on our 10-Q that those were assets where we weren’t paying any debt service and whatnot and the recoveries on those CMBS transactions are not expected to be much different from the actual balances on those transactions. So, the bank is – you can expect that the lender there will take our advice on what kind of recoveries to have and take the leads that we have given them in terms of how to maximize the recoveries. So that would take you down to 6 vacant properties at the end of the year if you think that those are being administered by someone else then. And then the other 2 Ganders are properties, where they are little harder to move, they are nice locations and one of them is right next to Walmart that’s brand new and so on. And what we may have to do is subdivide them and that’s fine. So, we will look at doing that and we have interest in the properties, that’s not like we don’t have interest in properties. So, I expect that we will resolve them for 2 of them.

[Operator:]

Our next question comes from Craig Mailman of KeyBanc Capital Markets. Please go ahead.

[Craig Mailman:]

Hey, guys. Chris, I just want to follow-up on the commentary in response to Vikram, you guys in the past have sold companies, you sound a little frustrated about where valuation is. I mean, have you or the board kind of pursued a potential privatization with outside money?

[ChrisVolk:]

No, we haven’t

[Craig Mailman:]

I mean, do you think that there is a bid at a significantly higher valuation than the private market versus the public market at this point?

[ChrisVolk:]

I couldn’t begin to tell you that. I mean, I think that when you are running a company, you should evaluate your cost of capital and your alternative is not just from day-to-day, but over the long-term, right. So, it’s – so on certain days, there maybe people that might value a company more and their market, but over like a year over the whole course of 2018 that may not be true. So, I think that you have to be very careful about that kind of stuff.

[Craig Mailman:]

Okay, that’s helpful. Then just one quick follow-up, I mean post the tax bill getting passed, are you guys seeing an increase in potential sale leaseback opportunities?

[ChrisVolk:]

We will not talk about the prices, we talk about pipeline.

[Cathy Long:]

Yes, no, Craig, I wouldn’t say that the tax bill passage has been driving any of that, but I would say that the deal flow is strong and the pipeline is strong, but not particularly related to that.

[Operator:]

Our next question comes from Todd Stender of Wells Fargo. Please go ahead.

[Todd Stender:]

Hi, thanks and thanks for the added commentary on your opening remarks. You have got the highest annual rent escalators in the net lease space can you go over the escalators you were able to get on the properties acquired in Q4? And then just with that theme just speak about how the conversations with sellers go, with the backdrop of a pretty robust economy we are in right now, can you push that higher or no matter what it’s going to be in that 1%, 2% range?

[ChrisVolk:]

So, we raised them 2% in the last quarter, which was 10 basis points more than prior quarter. Our cap rate was let’s say another 4 basis points higher. So together, the gross return is 15 basis points higher than the previous quarter. This 15 basis points make a trend no, I wouldn’t say that so in order – it’s one quarter. But we are seeing the cap rates are certainly remaining the same and we are – and while it tends to get sticky and it tends to be sort of sector specific. So we are seeing for example in we survey brokers and we don’t do a lot of business in the brokers market, but when we survey brokers we are seeing that assets are being listed for longer periods of time. We are seeing that certain factors are becoming a little bit less desired like drugstores and dollar stores potentially. We are seeing other sectors like restaurants being highly sought after, industrial assets being highly sought after. So, people have a tendency to sector rotate just like REIT investors do and so you see some of that what’s happening in the marketplace. Overall, I would say the cap rates in the private marketplace are still very low and are reflective of individual investors having a bias towards names that they know and trust and towards they have no ability to really underwrite portfolios and they have no – they are doing one property at a time, right. So there – and they have no access to deal flow. So, for all that reason, they are willing to accept at much lower yield than we will be willing to accept. So that’s about it. I mean, we are not seeing any sort of huge movement in relation to interest rates today.

[Todd Stender:]

Thank you.

[ChrisVolk:]

Okay.

[Operator:]

Our next question comes from David Corak of B. Riley FBR. Please go ahead.

[David Corak:]

Hey, good morning, everyone. Sort of start on projected sales obviously you haven’t given exact number yet or at all, but how do you think about the breakout of that between the three buckets that you guys talk about. And then within that what industries do you expect to fall into the more strategic bucket?

[ChrisVolk:]

We are not seeing anything that’s broad-based or sector specific. So we are seeing – so we could see clients in certain sectors having performance issues were the potential for future performance issues. And we might decide to get in front of that by selling some assets, but that’s not to speak of the whole sector. So, basically you can look across our portfolio and you know that restaurants is our number one sector, so then restaurants tends to be the number one thing that we sell in terms of – just numerically in terms of property talent. Last year, the biggest property we saw was an industrial asset and it was actually opportunistic. So, that was not by size, so that was the biggest asset we sold. Last year, 25% of the assets numerically made up the bulk of thinking say maybe like 80% of the gains it was probably bigger than 25% of the dollars, because that included the industrial asset that was expensive, but that made up the vast majority of it. We can – we are booking all the stuff with embedded gains from day 1. I mean, that’s very important to us. I mean, we want to be able to have better gains, because we are having better gains, then you have just much better liquidity options and you have much better chance to create market value-added, you have much better chance to have margins to the safety. So, for example, if you have – we have been able to periodically actually lower tenant rents and sell the property if we can get all our money back for properties that we are concerned about. So, we are basically helping those tenants work better, so that a subsequent owner of the property feels better about where the rent sales are or whatnot and then we are able to get all of our money back out and then we can redeploy it. And in some cases, we actually make profits on that stuff. So, I think that’s just very important to us and so we wanted to sort of be opportunistic and saw off more assets we could, it’s just a trigger we can pull and that’s important, because if you can take on average of 20 basis points of loss over the last 6.5 years a year and offset it with 10 basis points from gain and basically you have a portfolio that has very little frictional loss against AFFO per share and the internal growth becomes better. And I think that’s important to us.

[David Corak:]

Okay, that’s helpful. And then going back to your some of the prepared remarks, you talked about the various iterations that you have had of this strategy and the success in various different economic environments, but is an environment that I guess would be reasonably conceivable where single tenant kind of freestanding real estate underperforms broader CRE or do you feel kind of confident that the strategies that you have given kind of the potential economic scenario going forward stands to outperform?

[ChrisVolk:]

Well, I would say that there are say the single tenant real estate market is not monolithic, it is comprised of different companies having different strategies, different approaches to the market for different views on that marketplace. And some companies have higher payout ratios, some companies have lower rent increases, so when you are making a – when you are taking a view on STORE versus other companies, you have to sort of weigh those differences and you have to decide for yourself whether you like our approach or their approach or whatever. I am extremely comfortable with our approach. I mean, we have the highest lease escalators in our portfolio that we have ever had. I mean, this goes back to 1980, I mean, 2% may not seem like a lot for this quarter, but it is a lot. I mean, 2% on a levered basis is more for free from an AFFO perspective, there is some friction against that. You will have some vacancies and some friction against it, you would have to start off with a big number that’s meaningful and then cost us nothing whereas the other companies might post bigger same-store rent numbers than 2%, they can afford money for TI to do that. I mean, so, on a net basis 2% perhaps flowing right through was a big number. And so we feel good about the rent increases. Our AFFO payout ratio is the lowest we have ever had. And so that basically gives us the ability to roll cash and get basically another 2.5% or so growth. So, you are starting off with basically 5% plus embedded growth in AFFO per share before you turn the lights on and on January 1 and I think that’s just really critical. So, if you lose some of that to vacancies fine, at a 13 AFFO multiple, our external growth is not as exciting right. So, basically what happens is external growth adds another 1 point to 1.5 point of growth of AFFO growth per share if you guys would be nice and let us trade at 15 or 16 AFFO growth, then it gets like a lot more exciting right. But the irony of it is actually if you are really worried about interest rates and you want higher rates of return as you trade us at a better AFFO multiple, because we will put up much better growth numbers. But as it is, if you take our AFFO growth and you add our internal growth and you add some external growth, it’s going to still beat the 9% or 10% number that the S&P has posted for the last 40, 50 years and I think that’s heck of a think to say. So, I don’t know who else could say that and I think that I would say that we are – for this company anyway we were happy with where we are in this marketplace.

[Operator:]

[Operator Instructions] Our next question comes from John Massocca of Ladenburg Thalmann. Please go ahead.

[John Massocca:]

Good morning, everyone.

[Cathy Long:]

Hey, John.

[John Massocca:]

So, I know you kind of mentioned some potential leverage you could pull for proceeds if you felt that markets get even more challenged, would you ever consider maybe bringing up your leverage targets if that was the case and you thought there were still some attractive acquisition opportunities out there?

[ChrisVolk:]

I think the answer is that we were going to bring up leverage numbers who might do it in the short-term, but just not as a blip right. I think being a BBB company is important. We want to make sure that we sort of maintained ratios that are consistent with that. Personally I think that having a BBB rating in concert with having a structured finance A+ rating is just better than having a BBB rating by itself or by the way an A+ rating on our master funding conduit by itself, I just think that they are very complementary and long-term I think that they are going to cause us to lower cost of capital relative to people who don’t have those multiple choices. And the logic for that is that if you look at our unsecured debt ratios, okay, so basically unencumbered assets, unsecured debt ratio or unencumbered asset debt service coverage ratio and there are slides on our presentation to go through this. They are better from basically anybody else in space, no matter what the rating is, they are better than most any REIT no matter what the rating is and the reason for that is because the master funding assets are leveraged 70%, but we are basically leveraged on a consolidated basis, 45%, so you end up being sort of 33% levered on your unsecured debt and uncovered asset ratio. So I think that that kind of – that kind of synergy is going to help us maintain competitive leverage ratios in the aggregate, which lower our cost of capital and make us more efficient than anybody that would be having one of the other.

[John Massocca:]

That makes sense. And then kind of shifting gears, maybe the – from portfolio mix, your exposure to – would you get classified as service tenants has been kind of ticking down over the last 2 years is that 450 basis points since 4Q ‘15, what’s driving that, is that just more attractive acquisition opportunities, somewhere else or is that a conscious decision to shift portfolio exposures?

[Mary Fedewa:]

This is Mary. No it’s not a conscious decision. We are still very focused on service as our primary assets than your 70% right along. So it’s just the timing of acquisitions and timing of asset classes, but absolutely it’s our main focus the service industry for sure.

[Operator:]

This concludes our question-and-answer session. I would like to turn the conference back over to Chris Volk for any closing remarks.

[Chris Volk:]

Thanks operator. And thank you all for attending our year end earnings call. I am going to remind you that we have a biannual Investor Day coming up on the afternoon of April 11 at the New York Stock Exchange. And we are also going to ring the closing bell that day. And at that event, we plan to offer a high level look at what the future holds in STORE of market and portfolio discussion, customer case studies with STORE relationship managers and we are also going to deliver analysis of evidence based real estate investing in cognitive biases, which you are going to find fund, it’s kind of like money ball for real estate. I would also like to draw your attention to our modified investor presentation entitled values added by design, which follows on last year’s presentation by illustrating foundational elements that we designed from the outset and combined to make STORE the exceptional company that it is. The presentation also expands and the values that we add to our stakeholders and our important corporate values of strong governments and investor disclosure. And by the way STORE University as part of an effort to add value to our customers as Mary pointed out. And Part 1 of 9 has been posted if you are holding your breath and couldn’t wait to see it. If you want to binge watch now you can watch episodes less than 1 through 9 and just have a blast and/or you can wait to less than 10 gets posted sometime soon. STORE University is designed to have 10 modules from the start. So finally, we are able to follow this earnings call up with our CEO letter, which should be announced and posted on the website shortly. And thank you so much for listening. And have a great day. We will be around for questions if you need us.

[Operator:]

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.