STORE Capital Corporation
Q1 2015 Earnings Call Transcript

Published: 15 May 2015

[Operator:]

Good day. And welcome to the STORE Capital First Quarter 2015 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Moira Conlon, Investor Relations for STORE Capital. Please go ahead.

[Moira Conlon:]

Thank you, Laura, and welcome to all of you who have joined us for today's call to discuss STORE Capital's first quarter 2015 financial results. Our earnings release, which we issued this morning along with a packet of supplemental information, is available on our investor website at ir.storecapital.com under News & Market Data/Quarterly Results. I'm here today with Chris Volk, President and Chief Executive Office of STORE Capital; Cathy Long, Chief Financial Officer; and Mary Fedewa, Executive Vice President of Acquisitions. On today's call, management will provide prepared remarks and then we will open the call up to your questions. Before we begin, I'd like to remind you that comments on today's call will include forward-looking statements. Forward-looking statements can be identified by the use of words such as estimate, anticipate, expect, believe, intend, may, will, should, seek, approximately or plan, or the negatives of these words and phrases or similar words and phrases. Forward-looking statements by their nature involve estimates, projections, goals, forecasts and assumptions and are subject to risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in our forward-looking statements. These forward-looking statements speak only as of the date of this conference call and should not be relied upon as predictions of future events. STORE Capital expressly disclaims any obligation or undertaking to update or revise any forward-looking statements made today to reflect any change in STORE Capital's expectations with regard to thereto or any other changes in events, conditions or circumstances, on which any such statement is based, except as required by law. Please refer to our SEC filings and our Investor Relations website for additional information. With that, I would now like to turn the call over to Chris Volk. Chris, please go ahead.

[Christopher H. Volk:]

Thanks, Moira. Welcome, everyone to STORE Capital's first quarter earnings call. With me today are Cathy Long, our CFO; and Mary Fedewa, our Executive Vice President of Acquisitions. As you've all seen from our press release today, we're off to a strong start for 2015. In the first quarter, we posted AFFO of $0.34 per share and made investments of nearly $300 million. This sustains our growth momentum carried over from 2014. During the quarter, we declared a dividend of $0.25 per share, which represents an AFFO payout ratio of just under 74%, one of the lowest of all public net lease oriented companies. Our dividend is therefore highly protected and all the more so in light of our sustained organic growth. Our low dividend payout ratio combined with attractive lease escalations, averaging 1.7% annually, is designed to position STORE to deliver sustained and attractive internal AFFO growth per share. Factoring in the external growth we're achieving and we hope you can see the potential we have to deliver on the promise of exciting overall AFFO growth. Recent REIT stock price performance, driven by concerns of our potential interest rate hikes, tends to overlook the interest rate protections that our growth model provides. And, of course, our management team has a 35-year history of successfully navigating across a variety of interest rate environments to deliver steady growth. We ended the quarter with a run rate adjusted funded debt to EBITDA of just under six times, which also provides us with continued financial flexibility. As of March 31, we had drawn only $162 million of our $300 million unsecured credit facility and had almost $1.2 billion in unencumbered assets. On April 16, we contributed approximately $455 million of those assets to our A plus rated Master Funding conduit. We then issued $365 million in seven-year and 10-year notes, which fully repaid our short-term credit facility and added to our investment capacity. Since then, we have invested this liquidity, and begun again to access our unsecured credit facility, growing the level of unencumbered assets held by STORE. We expect that our total unencumbered assets will continue to increase, which will expand our financial flexibility and potentially broaden the menu of our financing options. Our recently issued Master Funding term notes bear a weighted interest rate of 4.06%, which is well within our projections, and is also the lowest rate realized by our conduit to-date. With almost 75% of the notes having 10-year maturities, the weighted maturity is approximately 9.2 years. So as of today, we have very little exposure to floating interest rates and a well laddered liability stack. These long-term fixed rate borrowings, like our expected internal and external AFFO growth, should serve to protect our shareholders in a rising interest rate environment. Since our inception, a hallmark of STORE has been our direct origination platform, that has resulted in an investment portfolio that ranks amongst the most diverse of any net lease market participant. The quality of our portfolio of profit center real estate investments is characterized in part by our histograms of tenant credit and contract ratings, which reflects the quality of the data we're able to collect, the systems we have developed and the disclosure that we are able to provide. At the end of the first quarter, we estimate that approximately 76% of our investment contracts at quantitative investment grade ratings under our proprietary STORE Score model. Qualitatively, we would place the percentage even higher. Our focus on the master lease contracts has resulted in master leases for 84% of our properties and 73% of our base rents for multi-unit investments as of March 31. Tenant default is the biggest risk faced by STORE and other net lease investment firms. To better manage this risk, we created and invested in sophisticated analytics that capture and evaluate ongoing corporate financial statements from virtually all of our customers as well as unit level financial statements from approximately 97% of the properties that we own. In the ordinary course of our business, we realistically presume a level of tenant defaults, property management costs and losses. In 2014, we outperformed our own expectations, because we actually had no tenant losses. In fact, our overall 2014 loss rate approximated a negative 25 basis points of assets, which represents the percentage of average assets during the year contributed by gains that we had on the sales of assets. As most of you know by now, we recently experienced a tenant default from the Heald College. STORE holds five of Heald's 12 campuses located in the Northern California. As a tenant, Heald had always exhibited strong cash flows and unit level economic performance, giving it a very high margin for error. A combination of external regulatory and legal initiatives resulted in the permanent closure of the institution, which was founded in 1863. We learned about the STORE closures on Sunday, April 26 and had STORE staff at each of our five campuses the next day. With all of this said, it's important for us to note that Heald only approximated about 1.4% of our base rent and interest as of March 31 and only about 1.2% of our future minimal rental payments as of that date. We anticipate that our recoveries from this default will be within typical ranges, which in our own experience is approximately 70% to 90%. Today, I can announce that we already have one school under contract to sell, and agreement in principal to lease another school under a 15-year triple net lease. This translates into a weighted recovery rate in excess of 90% for these two schools that together comprise almost 60% of our Heald exposure. That leaves the three smaller schools that comprise just under 0.5% (0

[Catherine Long:]

Thanks, Chris. I'll begin my remarks today with an overview of the results for our first quarter ended March 31, 2015. Next, I'll discuss our balance sheet and capital structure, followed by our guidance for 2015. Unless otherwise noted, all comparisons refer to year-over-year periods. Okay. Starting with the income statement, total revenues increased 56% to $61.5 million, primarily due to the growth in our real estate portfolio, which generated additional rental revenues and interest income. This also marks an increase of 11% from $55.2 million in revenues reported in the fourth quarter of 2014. Our portfolio grew 56% to $3.1 billion, representing 1,073 property locations at March 31, 2015 from $2 billion in gross investment amount representing 701 property locations at March 31, a year ago. This also reflects a 10% increase in the size of our real estate investment portfolio since year end 2014. Our portfolio's base rent and interest on an annualized basis was approximately $263 million at March 31, as compared to a $169 million a year ago. As Mary will discuss, the weighted average cap rate for real estate investments closed during the first quarter was about 8.3%, slightly higher than the 8% weighted average rate we expect for all of 2015. Total expenses for the first quarter increased to $44.3 million compared to $30.6 million a year ago. Depreciation and amortization expense generally rises in proportion to the increase in the size of our real estate portfolio and so for the first quarter, about half of our increase in total expenses was due to higher depreciation and amortization expense. Interest expense increased about 20% to $17.2 million from $14.4 million due primarily to an increase in long-term borrowings used to partially fund the acquisition of properties for our growing real estate investment portfolio. The long-term debt we added since March 31, a year ago included one series of STORE Master Funding net lease mortgage notes payable of $260 million in principal amount completed in May of 2014 and $26.5 million of traditional mortgage debt. Property costs increased to $295,000 for the first quarter of 2015 due primarily to the accrual of property taxes on the five Heald College properties, whose leases were terminated shortly after quarter-end. We anticipate that our property costs will continue at an elevated level during the period while these properties are being remarketed. G&A expenses increased to $6.6 million from $4.2 million, primarily due to the growth of our portfolio, staff additions to support the growth and the increased costs associated with being a public company. As a percentage of revenue, G&A was consistent with the year ago period, at 11% of revenues. Net income increased to $17.1 million or $0.15 per basic and diluted share compared to $9.5 million or $0.15 per basic and diluted share. The increase in net income was primarily due to the additional rental revenues and interest income generated by the growth in our real estate investment portfolio, offset by a $1 million provision for impairment on one of our Heald College properties. In comparison, net income for the first quarter of 2014 included a $743,000 gain on the sale of one property. AFFO increased about 80% to $39.5 million or $0.34 per basic and diluted share compared to AFFO of $21.9 million or $0.34 per basic and diluted share in the first quarter of last year. This is also a 17% increase from last quarter's AFFO of $33.7 million, which highlights our strong sequential growth. Again the increase in AFFO was primarily driven by the revenue generated by our portfolio growth, partially offset by the increase in interest expense related to borrowings, associated with that portfolio growth and the higher operating expenses to support the growth. For the first quarter of 2015, we declared a regular quarterly cash dividend of $0.25 per common share to our stockholders, which was paid on April 15. This represents a payout ratio of about 74% on AFFO per share of $0.34. Now, I'll provide an update on our balance sheet and capital structure. During the first quarter, we fully deployed all the remaining net proceeds from our November 2014 IPO, and borrowed a $162 million under our unsecured credit facility to fund additional real estate acquisitions through March 31. As of March 31, 2015, we had $30.3 million in unrestricted cash and cash equivalents, $138 million available on our credit facility, and approval of unencumbered assets aggregating approximately $1.2 billion. Our total debt outstanding was $1.44 billion at March 31, up from $1.28 billion at the end of 2014. We measure leverage using a ratio of adjusted debt to EBITDA. Because of our high rate of growth, we look at this ratio on a run rate basis, using our estimated run rate EBITDA. Based on our real estate portfolio of $3.1 billion at March 31, we estimate that our leverage ratio on a run rate debt to EBITDA basis was approximately six times. Subsequent to the end of the first quarter on April 8, we entered into a $50 million unsecured loan facility with the bank as a temporary supplement to our borrowing capacity under our unsecured revolving credit facility. Borrowings under this loan facility will generally bear interest at one month LIBOR plus 2%. This facility has a three-month term with a one month extension option, which will provide additional liquidity to us through the beginning of August. As Chris discussed, also after quarter end on April 16, 2015, we issued our sixth series of STORE Master Funding net lease mortgage notes consisting of $365 million of A plus rated Class A notes and $30 million of Class B notes. The Class A notes are segregated into two tranches, $95 million of seven year notes with an interest rate of 3.75% and $270 million of 10-year notes with an interest rate of 4.17%. As of each – as with each of our previous Master Funding note series issuances, the Class B notes were retained by STORE. Between our A-plus rated long-term debt conduit, our short-term unsecured borrowings and over a $1 billion in unencumbered assets, we continue to maintain an efficient capital structure that provides us with access to long-term low cost capital. Now turning to our guidance for 2015, we are raising our expectations for AFFO per share from a range of $1.33 to $1.39 to a range of $1.34 to $1.40. Based on our robust acquisition activity for the first quarter and positive outlook for the remainder of the year, we've increased our guidance on acquisitions for the full year ending December 31, 2015 to $1 billion, up from the $850 million guidance that we provided in February. We continue to expect our average cap rate for the year to be about 8%. The timing of acquisitions is expected to be spread throughout the remainder of the year, though history would show us that acquisition activities generally weighted towards the end of each quarter and that there's often a slightly higher acquisition activity in the fourth quarter. Regarding leverage, we continue to target a run rate debt to EBITDA level of between 6 times and 7 times which translates into a loan to portfolio cost of roughly 50%. And finally G&A costs are expected to be between $29 million and $30 million for 2015, including commissions and equity compensation. As we've mentioned before, we expect G&A costs as a percentage of our portfolio assets to trend lower over time due to our scalable platform. That concludes my remarks, and now, I'll turn the call over to Marry.

[Mary Fedewa:]

Thanks Cathy, and good morning to everyone. Today, I'm going to provide some color on our portfolio and an update on what we're currently seeing in the market. I'll begin with our portfolio. As Chris mentioned, in the first quarter, we added nearly $300 million in new investments at an initial cap rate of about 8.3%, which was slightly above our target of 8% for the year. As we've described before, we're in a flow business and cap rates will fluctuate slightly from quarter-to-quarter based on the mix and timing of transactions. That said, given our investment activity to-date and our expectations for the second quarter, we remain comfortable with our initial 8% rate estimate for the year. Consistent with our investment approach, approximately 75% of the transactions we closed were originated directly. We were pleased that about one-third were with existing customers, who know firsthand the value we deliver. From the start, we have focused on building our portfolio by creating contracts with a brick-by-brick approach, and we're pleased to report that this continues. In the first quarter, we completed 32 new transactions at an average deal size of $9 million. We continue to apply our disciplined approach to selecting the right investments for our portfolio. And from a risk perspective, the contracts we created in the first quarter are consistent with our investment strategy. We know this, because we monitor our entire portfolio using third-party risk algorithms. We then overlay unit level performance to determine a contract rating. As of March 31, our median contract rating was A3. An approximate 76% of our portfolio had an investment rate contract rating using our STORE Score model. At the end of first quarter, our portfolio of 1,073 properties were located across 46 states. Of the total, 74% were service properties, 15% were retail and 11% were industrial. Our top five concepts were Ashley Furniture HomeStore, Gander Mountain, Applebee's, Popeyes Louisiana Kitchen and Starplex Cinemas, taken together, these investments represent 13.8% of our total annualized base rent and interest. In addition, we had 246 customers spread across 69 industries with about 380 contracts. Our portfolio remained highly diversified with no single customer representing more than 3.5% of annualized base rent and interest. And combined, our top ten customers totaled less than 19% of annualized base rent and interest. We are proud of our portfolio diversification, which is among the highest of any public net lease market participants. Now, turning to what we're seeing in the market. Our second quarter is off to a good start and as of today, we have closed over $220 million of transactions, bringing our year-to-date acquisitions to about $515 million. So far in the second quarter, we're seeing cap rates slightly above 8%. As Chris mentioned, we're running ahead of our plan for the year and this is why we've increased our 2015 acquisitions guidance to $1 billion. We're pleased that our flexible net lease financing solutions continue to create significant demand in the marketplace. We believe this reflects the fact that we are creating real value for our customers that they're willing to pay for. In conclusion, we're excited about the volume and the quality of the transactions we're seeing. With that, I'll turn the call back to Chris for his final remarks.

[Christopher H. Volk:]

Thank you, Mary. Before, I turn the call over to questions, I wanted to again highlight the detail contained within our earnings release today, and also our supplemental information packet that is posted on our website. We've designed both to provide best-in-class information regarding STORE. As always, my personnel favorite chart is the one on the page 10 of our supplemental information packet, which contains a complete tenant and contract quality histogram. That information is derived from tenant financial statements applied to third-party risk algorithms, as well as, unit-level financial statements that we realized from about 97% of our assets. We will expand or modify our supplemental information packet from time-to-time based on your comments. But we began this effort by disclosing statistics that we believe are important in assessing the results and the quality of STORE's diverse portfolio of profit center real estate investments. This quarter, we added a statistic for the median four-wall unit-level coverage, which stood at about 2.4 to 1 versus the 1.95 to 1 for a coverage that is loaded with indirect overhead costs. We added the four-wall coverage statistic because not all participants in our industry apply indirect costs or an equivalent amount of indirect costs, so we wanted to be able to illustrate the difference. Obviously, we believe that the loaded coverages are a better way to look at asset essentiality because tenants typically look to be able to cover these indirect costs. Note also that we talk about median coverages rather than average coverages. Average coverages are not typically as good at illustrating portfolio risk because average is applied to unit-level cash flows across the portfolio, whereas our real investment risk is based on a contract-by-contract basis. Averages can also be more volatile because they're influenced by numerical outliers. So to illustrate this, the weighted average fully loaded coverage for STORE's portfolio was over three times as of March 31 or more than a full turn higher than our median number. However, we have elected not to report this number because we believe it to be less informative. Likewise, we tend to talk about median tenant credit ratings and lease contract ratings, our unit-level coverages are embedded in the contract ratings that you can see in the full distribution on page 10 of our supplemental information packet. Anyway, I hope you'll find the disclosure helpful and we always welcome your feedback. So with this, I conclude my comments and turn the call over to the operator for any questions you might have.

[Operator:]

At this time, we'll begin the question-and-answer session. And our first question will come from Derek Van Dijkum of Credit Suisse.

[Derek Van Dijkum:]

Hey, good morning.

[Christopher H. Volk:]

Good morning.

[Catherine Long:]

Good morning.

[Derek Van Dijkum:]

Just wanted to get a little more info on the Heald College and on the sale of the one asset and the potential lease on the other?

[Christopher H. Volk:]

No problem. Well, I should also say we're – I'm surrounded by our entire leadership team, so we have a pretty deep bench. And Mike Zieg runs our Portfolio Servicing and I'll just turn it to Mike to give some color on that.

[Michael J. Zieg:]

Sure. As Chris noted in his earlier commentary, we have the 60% or almost 60% of the Heald exposure with a resolution, as he mentioned, we're selling one property and leasing another for combined recovery of about 90%. So, we're very pleased with that progress we made so far. The other assets are all – these are all well located facilities. They are in office – small office buildings of less than 50,000 square feet. They're well located, very suitable for other users. Obviously, the first goal of ours is going to be find another education user in there because that's how they're currently configured. So we expect these will get rented or sold and be within our typical recovery rates of what we expect overall, which over time range 70% to 90%.

[Christopher H. Volk:]

And (0

[Derek Van Dijkum:]

Got it. Now, given that you've paid roughly sort of, I guess, $40 million for the five assets, how does your calculus, I guess, change potentially going forward? When you sort of – because I think you get a lot of potential sort of purchase price diversity, when you buy instead of five assets for $40 million, 40 assets for a $1 million. How does that calculus I guess, come into play?

[Christopher H. Volk:]

Well, that's a good question. I mean, I think in our business, where you're dealing with granular asset portfolios, whenever you make big asset plays, which we'll do from time-to-time, there's less diversity in the assets, so you have to be obviously a strong believer in those assets, and you have to believe that you're buying those assets at prices that are supportable in the marketplace. There is always going to be a difference between the price that we buy an asset at and the price it would read that out at, if we were dark. So we can't buy – we can't run around the country and buying assets at dark values, because nobody would sell us assets for dark values when they're operating assets. So an asset like these five facilities, these were well located facilities that had really great student attendance and pretty ballistic coverages when they were running. And so, we were – and they were all, by the way, second – they were all in their second life. So they initially started their life as office buildings and then they were reconfigured for education. So keeping them as education assets, as Mike said, is obviously the easiest thing to do and it's going to get you the highest rates of recovery. I would tell you that on the three assets that we have, we are having interest in those assets. And a lot of that interest comes from other education providers, because it's hard to find these kinds of assets that are zoned like that and that have sort of like an office building with too much parking, if you think about it that way. So, at the end of the day, assuming that we get the same kind of recoveries and we have the same diversities and this investment will prove out to be no different from any restaurant defaulter, anything else that we would have had and that's the idea.

[Derek Van Dijkum:]

Got it. And then lastly, given the latest issuance of your STORE Master Funding notes, it looks like you guys did again sort of a combo seven-year and 10-year maturities. I guess, how come you guys don't look at sort of going longer-term and sort of trying to match your leased term or your weighted average lease term with your debt maturities?

[Christopher H. Volk:]

Well, technically speaking you actually can't match fund leases. So, let's say you have 15-year leases, which are average leases, doing 15-year notes won't match fund them. So, what REITs can do is match fund cash flows, so that you have to focus on match funding cash flows as opposed to lease contract. Because after all a 15-year lease is going – has renewal option. So, it's going go on, on and on. And so what your – so in theory, if you think about that way, our dividend payout ratio is 75% of AFFO, assuming that we are able to reinvest that or use the proceeds to pay down debt and assume that that amount equals our debt maturities in any given year, then we're basically asset liability neutral to the extent that we have more cash flow than we have debt maturities, we're asset sensitive and to the extent we have more liabilities that (0

[Derek Van Dijkum:]

Right. Well, I guess if I look at your free cash flow this year, after dividends, it's call it roughly $40 million. In 2017, 2018, 2019 you're going to start seeing some pretty big maturities. I mean it looks like you, in order to sort of get your – get to that sort of level where your free cash flow starts to – is able to pay-off any maturities in any given year, I mean you're going to have to increase your free cash flow quite substantially from where it is today.

[Christopher H. Volk:]

Well, I mean, this is for – a) I would say this is a growth REIT. So I mean...

[Derek Van Dijkum:]

Right.

[Christopher H. Volk:]

...if you think about the maturities of those Master Funding issuances, the 10-year one, if we wanted to have an equivalent amount of cash flow that's correct, that we have to be a bigger company, which we fully expect to be a bigger company. If we happen to be liability sensitive in one year it's not the end of the world. I mean a lot of REITs will have some years where they're liability sensitive. In the case of our earlier debt maturities, those debt maturities also happen to be at the highest interest rates. So they're close to 6% debt, which I would be glad to pay that off today. Then I don't know what the debt is going to be in three years or four years, but I'm guessing that they'll probably be not materially different from what the rate is, so that we won't have a lot to worry about.

[Derek Van Dijkum:]

Okay, fair enough. Thank you.

[Christopher H. Volk:]

Okay.

[Operator:]

And the next question comes from Vikram Malhotra of Morgan Stanley.

[Vikram Malhotra:]

Thank you. Could you just, if it's possible, could you give us what the sale proceeds were from the Heald College transaction and then just what the new rent levels are for the other assets?

[Christopher H. Volk:]

Well, the assets that we're leasing out were basically getting the same rent that Heald was paying. And the asset that was being sold, it has not closed yet. So, I mean, so in fact the rent hasn't begun on the asset that is being leased out. So that rental will commence later on in the year. But in terms of giving you the exact specifics on both of those I'd rather not get that granular.

[Vikram Malhotra:]

Okay. And maybe if you could just say where in the bar chart – the histogram of these – of the credit, where, kind of – where did that fall or which category did Heald fall in?

[Christopher H. Volk:]

Heald was actually at the time kind of in the A1 area I think. And part of that is because – part of that was because, if you looked at the transaction, Heald as a credit, had no debt at the asset level, at the credit level. And then the coverages when we started off doing the deal were around 13 to 1, and even as the most recent financial statements we had, the coverages were close to 9 to 1. So one of the things about the histogram that I mentioned earlier too, is the histogram is a quantitative histogram, it's not qualitative. So there are qualitative features that can affect credit risk. In this case, the overriding qualitative feature was that, Corinthian ran into a dispute with the Department of Education and with the State Attorney General in California which ultimately caused its demise. And it should be pointed out, by the way, that they had divested of many other locations around the country, outside of California, which stay open today, which actually didn't have the yield level economics that our assets did. So the fact that they were in California have a lot to do with the fact that they're not open today. So anyway that's a qualitative discussion. Now, qualitatively there are – the qualitative features tend to work more often the other way. So for example, we could have an asset with an industrial borrower. We have a hugely favorable capital stack. They have debt, but the debt is very junior to us. We could be in assets that are very inexpensive, which happens a lot of times, so we're just in the assets very cheap. So there is certain transactional qualitative issues that just don't appear on this chart. But – so what will happen with this transaction will be that we'll replace this transaction, we'll have one new customer, which we're excited to have, which is a well capitalized, well funded education company, not dependent on the Department of Education, and which will appear extremely strong from a contract rating perspective. And then, we'll have the other one will be sold, and we'll take those assets and redeploy them. And I should just like comment to you that we always have a choice, do we sell the asset or not. We took $1 million write-down, because we're selling the asset. If we chose to own the asset and not, sell it, we wouldn't take the write-down at all. In fact, we could probably rent it out for less money and not take out a write-down. So I'm less about the accounting implications of all this than I am about trying to be able to take the cash that we get and redeploy it and maximize adjusted funds from operations per share. I am a finance guy, not accounting guy, and I'm into sort of real results. And so that's what we're trying to generate.

[Vikram Malhotra:]

Okay. And then, just maybe a bigger picture question, there seems to be a couple of kind of maybe large sale lease back deals potentially that have taken place over the last quarter or so, and maybe a few teed up for the next few quarters. What – I know you've obviously been very granular in your approach, but what sort of size would you be comfortable with and maybe would you engage in a larger transaction?

[Christopher H. Volk:]

The biggest tenant exposure we have today is Gander Mountain, which is around 3.4%...

[Catherine Long:]

3.2% (0

[Christopher H. Volk:]

...3.2% (0

[Vikram Malhotra:]

Thank you.

[Christopher H. Volk:]

Sure.

[Operator:]

And the next question is from Craig Mailman of KeyBanc.

[Craig Mailman:]

Hey guys, sort of a follow up to that last question. Just curious from – just from a deal perspective or technical perspective, what are some of the challenges on some of these potential large sale lease backs. We've heard some of the restaurant guys are kind of getting agitated to do it, but just curious from kind of tax consequences and other things that may be kind of impediments for you guys to get your arms around it.

[Christopher H. Volk:]

So, expand the question and get more specific for me.

[Craig Mailman:]

What would be the biggest challenges for you guys to move ahead, with that kind of transaction from kind of a technical perspective versus wanting to keep your tenant exposure at a certain level or from a credit perspective?

[Christopher H. Volk:]

Well...

[Craig Mailman:]

Maybe there's nothing, I don't know, I'm just curious.

[Christopher H. Volk:]

Yeah. I mean, I would say that, first of all, if you're thinking about some of the transactions that we're active as shareholders are rooted in restaurant companies and are looking to having divested real estate and are looking for tax efficient ways of getting this done. I think that we think that's a very real possibility. Whether or not we could play a role in some of that would be – remain to be determined but I think that from an investor perspective and – of any investor in STORE, one thing that we can't do is play in some big portfolios and so in some way that's going to hurt the diversity of the company that we've created. And so, we don't intend to do that. From a tax perspective, taxes are a large issue for people that own real estate because if you – especially if you run a C-corporation and if you've been depreciating real estate for many years, when you sell the asset, the recapture is taxed at 34% or somewhere in that neighborhood. So – and it's material and it can actually destroy the whole idea of doing a sale leaseback, if you have to pay that kind of tax leakage. I mean, why bother doing a sale leaseback, you can just debt finance a lot easier if you're looking for after tax dollars. So – and these issues don't just affect big companies that are looking to sell real estate that you might have read about, these issues affect smaller companies as well that have held on to real estate. So if you think about the solutions that we provide our tenants, our customers, some of those solutions have been solutions designed to improve the tax efficiencies of transactions, and those are the kinds of things that allow us to generate nice returns that we're creating a lot of value for them.

[Craig Mailman:]

Okay. That's helpful. And then just a quick clean up one. You had mentioned that you guys gave us the coverage on a median basis rather than an average just because of the ability to skew but what's the range of your coverages, kind of low to high?

[Christopher H. Volk:]

The range is really wide like the highest coverage – what do you think it is, Michael, 13, 14 (0

[Michael J. Zieg:]

Yeah, 13 and 14 (0

[Christopher H. Volk:]

Yeah. So, you really want to focus on medians. I mean the medians is where the contract risk really is, that's where we take the risk. And I wanted to make that point today, it's my opportunity to educate the world a little bit, have to look at stuff and I think the median is the way you have to look at it, the averages skew – gets skewed.

[Craig Mailman:]

Right. But what's the low end of that, kind of how – what's the bottom that you guys would underwrite to?

[Christopher H. Volk:]

Well, you could see that on the left, on the histogram, you can actually see – you can pretty much see that, because you could see what the effective credit ratings are. So, like to focus on just the unit level coverage by itself is missing the point because, the risk is a combination of the unit level and corporate risks. And so, together you're taking an aggregate risk, so if you look at the histogram you'll see that we have some assets, we have a handful of CCC (0

[Craig Mailman:]

Okay. Great. Thank you.

[Christopher H. Volk:]

Thank you.

[Operator:]

And our next question comes from Ki Bin Kim of SunTrust Robinson Humphrey.

[Ki Bin Kim:]

Thank you. So just a quick question on the Heald College and maybe some other leases that tend to – that will expire. But more specifically around Heald, what kind of CapEx would you have to spend on that new lease?

[Michael J. Zieg:]

Well, the new lease actually because we targeted an investor – I'm sorry, an education user and there was high demand for the property, we're actually putting no TIs into the property on the new lease and it's a triple net lease. So effectively no difference in Heald, we're getting 100% of rents and just did a quick switch with another tenant and put them in there and that's kind of our business model. The real estate we're investing in is very fungible for other users and in high demand, so if it becomes available like this one was, there is literally a feeding (0

[Ki Bin Kim:]

And you said you're working on – so that was two out of five buildings, so how about the prospects for the other three?

[Michael J. Zieg:]

Yeah. We have varying levels of interest in the other three, again they're all well located facilities in Northern California and there's other education institutions that are either expanding or relocating that we've been in discussions with so.

[Christopher H. Volk:]

By the way, I would say that the experience that we're having here is not unusual. So in our history of doing this for about 30 years, the average time it takes to fix a property is six months. When we do the budgeting and when Cathy does her budgeting, we're always assuming a certain level of defaults. We're assuming a certain level of property management costs. We're assuming a certain level of losses on relapse. I mean – so, I mean, you always make those assumptions whenever we create earnings, our AFFO estimates at the beginning of year. So you have two of these properties of the five that are already fixed and now you got to deal with the other...

[Catherine Long:]

Smaller assets

[Christopher H. Volk:]

..smaller assets, the three assets. And if takes a little bit longer, our average, it could be six months or it could be shorter, but at this point it's – I mean, it could be longer. So but at the end of the day, I mean you're talking at this point about 0.5% (0

[Ki Bin Kim:]

Yeah. I realize I need to keep it in perspective. It's not that big of a deal. Just one other question on Heald and maybe your STORE Scores. You mentioned in the call that it was in the A1 area in regards to your histogram. I think that equates to, from your presentations in the past, maybe a 0.06% default rate. And I realize this is because of a regulatory issue and some other things involved, but does something like this change your thinking at all about how you guys come up with your STORE Scores for credit risk?

[Christopher H. Volk:]

Not in the least. I mean the STORE Score is what it is. It's a quantitative, emphasize on quantitative, measurement of risk, it is not qualitative. So if you think about people that have the government as a partner, I mean, in here you have effectively the government as a partner, and the government controlling the revenue streams. If that partner decides to change what they do, then you can have – you can experience diversity. (0

[Ki Bin Kim:]

Okay. And, yeah, I apologize if I think (0

[Catherine Long:]

We're still looking at 8% as being a good weighted average rate for the whole year.

[Ki Bin Kim:]

Okay. That's it. Thank you very much.

[Operator:]

And the next question comes from Andrew Rosivach of Goldman Sachs.

[Andrew L. Rosivach:]

Hey, good morning everybody. I wanted to ask, Chris, you made that point on 2016. I wanted to ask you a couple of questions on it. You've got an acquisition pace of $1 billion in your guidance. Obviously, you were running faster than in the first quarter. You ran faster than that a little bit last year. Is there any reason why you've got to slow down, or are you just being careful?

[Christopher H. Volk:]

I would say that we're trying to give you guidance on what we think our (0

[Andrew L. Rosivach:]

I apologize, Mary, did you say what you've done in April or kind of year-to-date?

[Mary Fedewa:]

Second quarter to-date, we've done $220 million and that was...

[Catherine Long:]

Through yesterday.

[Mary Fedewa:]

...through yesterday, yes, and for the year-to-date at $515 million, Andrew.

[Andrew L. Rosivach:]

Terrific. Thank you. And one other on the 2016 run rate, Chris. I'm guessing that Heald, you've got just some natural drag over the course of the year that if you do get a 70% to 90% recovery rate, there's rent that you're not getting now that you would get in 2016, there's capital that you don't have now that you would get in 2016. Do you have any sense of the order of magnitude of kind of the drag, if you will, in 2015 that's probably going to go away next year?

[Christopher H. Volk:]

Yeah, well, I mean, first of all Heald itself is only 1.2% of our run rate, and if you look at it on 2016, it's probably going to be less than 1% of the run rate, if you were to take Heald overall, right. But keep in mind, that when we give estimates, as always, we're factoring in a certain level of defaults anyway, I mean, you have to do that in our business, I mean we can't assume that we have 100% occupancy all the time. So – and we can't assume that we don't have any property costs, it would be unwise for us to make that assumption.

[Andrew L. Rosivach:]

That's right, Chris. What is – in your guidance, what is the credit loss reserve that you guys run through?

[Christopher H. Volk:]

Well I mean, it just – it ranges from year-to-year, it sort of scales up over time, but it's kind of (0

[Andrew L. Rosivach:]

So it's (0

[Christopher H. Volk:]

Yeah, it starts off at like 1% to 1.5% of – from a default 1% to 1.5%, and we can stretch (0

[Andrew L. Rosivach:]

Got it. And then the last thing on Heald, there were a couple mortgages under the properties, right, that were non-recourse?

[Christopher H. Volk:]

We had – yeah, that's true. So we had $40 million worth of investments, $40 million or $39 million.

[Michael J. Zieg:]

$39.6 million. (0

[Christopher H. Volk:]

$39 million, whatever. So and of that two of the properties were in a CMBS facility and three were in our own conduit. In terms of the properties that have been fixed, one of those was the CMBS conduit property...

[Catherine Long:]

Right. (0

[Christopher H. Volk:]

And that's the one that's being re-rented. And then the one that's in the – one of the properties that's in our conduit is being sold.

[Andrew L. Rosivach:]

Got it. So one of the properties where you have non-recourse single asset CMBS is one of the ones that hasn't been addressed yet?

[Christopher H. Volk:]

Right, I mean, that's correct.

[Andrew L. Rosivach:]

To make this even tinier than it already is.

[Christopher H. Volk:]

Yeah.

[Andrew L. Rosivach:]

All right, thanks a lot everybody.

[Christopher H. Volk:]

Thank you.

[Catherine Long:]

Thank you.

[Operator:]

And next we have a question from Cedrik Lachance of Green Street Advisors.

[Cedrik Lachance:]

Thank you. I just want to go back to the coverage ratios. What percentage, if any, of your portfolio has a coverage ratio of less than 1 or less than 1.25?

[Christopher H. Volk:]

Well, again, it kind of depends if you're talking about fully loaded or not fully loaded. Do we have that number in front of us? I mean it's a relatively small number. I mean you can see like – I really – I would just about rather you just focus on the histogram on page 10 because it's sort of – basically if you look at the blue lines, so you see the – which is the credit contract rating, you'll see that these slivers of blue lines around CCC, (0

[Cedrik Lachance:]

Okay. And then, sorry to go back to the college question, but I'll avoid talking about the one that closed. I won't even use the name. Just in big picture terms, though, you do have about 5.5% of your income that either comes from junior colleges or colleges and professional schools. How do you think about that category going forward, given what we've learned over the last year in terms of government intervention and how the environment has changed in terms of these professional schools, in particular? What percentage of your portfolio do you want in the category? How do you think about underwriting it? Will you make more investments in it? So if you could cover all of those, it would be great.

[Christopher H. Volk:]

Okay. If you look at our portfolio today, outside of Heald we have three, for-profit tenants remaining that are for-profit. They're all trade school type tenants. Most of the degrees that they offer are Masters and Ph.D degrees and four-year degrees. So Heald was classified as a junior college, the rest of their for-profit – the other four assets we own are not They're – (0

[Cedrik Lachance:]

Good. Thank you. Just the last one. You have a stated goal on that EBITDA front of 6 times to 7 times. So now you just got into the low end of that range on a fully adjusted basis. I would imagine as you fulfill your expected $1 billion this year, you'll creep up to the middle, at the very least, the middle of the range. So at what point is equity contemplated in your funding plans?

[Christopher H. Volk:]

Well, we have – we can be a little bit flexible about that and of course we can move north of seven times for a short period of time and that's what we want to do, so for the interim period. So we're not going to sort of have seven times as a cap and then just say that we have to just do it right then and there. But clearly given the volume that we're doing, there will be equity out there. And we're excited to do that because the reason we're deploying the equity and the reason – if we have the excess (0

[Cedrik Lachance:]

Okay. Great. Thank you.

[Christopher H. Volk:]

Thank you.

[Operator:]

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

[Christopher H. Volk:]

Well, operator, thank you very much and thank you all for attending. And on behalf of everybody here at STORE, it's – we're delighted to make the call. And you know how to find us if you have any questions. So thanks so much. Good-bye.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.