STORE Capital Corporation
Q3 2015 Earnings Call Transcript

Published: 12 Nov 2015

[Operator:]

Good day, and welcome the STORE Capital third quarter 2015 earnings conference call. [Operator Instructions] I would now like to turn the conference over to Moira Conlon, Investor Relation for STORE Capital. Please go ahead.

[Moira Conlon:]

Thank you, Carrie, and welcome to all of you who have joined us for today's call to discuss STORE Capital's third quarter 2015 financial results. Our earnings release, which we issued this morning along with packet of supplemental information, is available on our Investor website at ir.storecapital.com, under News & Market Data, Quarterly Results. I am here today with Chris Volk, President and Chief Executive Officer 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 would 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 the words such as estimate, anticipate, expect, believe, intend, may, will, should, seek, approximate, or planned, or the negative 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 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 in 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 Volk:]

Thanks, Moira, and good morning, everyone. And welcome to STORE Capital's third quarter 2015 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, 2015 is taking shape to realize operating results well above our initial expectations. A year ago today, as we were planning to introduce our company to the public equity markets, we felt we could commit to 2015 investment activity, net of any asset sales, of approximately $750 million. Over the past year, we have certainly raised this amount, and today believe we will close out the year with a record net annual investment activity approximating $1.1 billion. We believe that we will be able to realize an average lease rate of approximately 8%, and we will do this. We believe that our average fixed rate term borrowings cost on new term debt this year will be 5%. And we will realize weighted average borrowing cost materially less, with some of the best investment spread in the 35 year history of our leadership team. Vacancies and property management cost that we initially budgeted for has come in lower than we estimated. Operating costs have come in approximately what we initially expected, but the most meaningful variance for the year has been the timing of our investment activity. Record investment activity in the second quarter increased the predicted weighted days outstanding of 2015 investments. We added to this with a positive variance in the third quarter with record third quarter investment activity, again, more heavily weighted to the front half of the quarter than we expected. Altogether, these investments, financing and operational achievements have allowed us to steadily raise our guidance for AFFO per share. Initial guidance of $1.33 to $1.39 in March this year was gradually raised to a range of $1.38 to $1.42 last quarter. And that increased guidance together with our outlook on 2016 led our Board to approve an 8% dividend increase, which was paid in October. Today, with about a-month-and-a-half remaining in 2015, we're happy to announce a meaningful increase for 2015 AFFO guidance to $1.45 and to $1.47 per share. For the third quarter, we generated approximately $263 million worth of investments, which in turn set a new record of nearly $950 million of investments for the first nine months of the year. For the year, about 30% of the investments we have made in profit center real estate have been with the existing STORE customers. During the third quarter, our average investment transaction continue to approximate $8 million with 32 transactions. And very importantly, we added 14 new customers, concluding the quarter with a total of 288 customers, providing our shareholders with an extremely granular portfolio of net leased assets. And most important of all is what this signifies, STORE has absolutely struck a chord with our target customer base, providing needed long-term capital solutions that are a clear improvement to our customers' alternatives. By the end of 2015, we will have organically grown our portfolio to about $4 billion. And we will get there by filling capital needs from our large and growing customer base for efficient long-term capital solutions. In the process, we will have created diversified portfolio of predominantly investment-grade net lease contracts, backed by a portfolio of profit center real estate that today is delivering for both our shareholders and customers in equal measure. So here are a few specifics for the third quarter. Our weighted average lease rate for investments made during the third quarter stood at just over 7.8%. Year-to-date, the weighted average lease rate for 2015 stands at about 8.15%. The average annual contractual lease escalation on our new investments approximated 1.8%. The weighted average primary lease term for our new investments was approximately 17 years. The median new investment tenant credit rating profile was Ba1. The median new investment contract rating, which is our STORE score, was A1. Our average new investment was made approximately 92% of replacement cost; 78% of the multi-unit investments we made during the quarter were subject to master leases; and finally, all the assets we acquired during the quarter will deliver us unit-level financial statements. Altogether, our portfolio performance during the third quarter was strong and we closed the quarter with an occupancy rate of 99.8%. Earlier in the year, we experienced five vacancies from a single for-profit college tenant. As of today, those vacancies have planned resolutions, with our recent agreement to sell the last remaining property. In the end, we will have sold three of the five assets and lease the remaining two. And all five, by the way, will continue to be used as education facilities. In total, the recovery rate will be almost 90%. This is a nice result, but it's important to also keep in mind that our gains on selected property sales through the third quarter averaged 10% after transaction cost. You should think of this as a negative default rate or an added form of recovery that virtually eliminates losses arising from our five STORE vacancy. With the five locations resolved, vacancies at the end of the third quarter were nominal. Always keep in mind that vacancies are a part of the business we're in. We budgeted for them at the beginning of this year and concluded the third quarter modestly under budget. Cathy Long will provide you with our initial guidance for 2016, which will also presume a level of tenant non-performance. As always, what is important to us is building a portfolio having margin for error. The ability to realize margins for error is embedded in lease rates, generally in excess the auction marketplace, a portfolio centered in contracts we deem to be investment-grade, assets purchased for less than their cost to replace, assets having rent per square foot supported by the local marketplace and an extremely high-level of portfolio diversity. You will see from our supplemental disclosure on our website that the health of our overall portfolio continues to be very sound. The median tenant credit risk remained at around Ba1, and we deem approximately three-fourths of our contracts to be of investment-grade quality. Turning to our financial position. We concluded the quarter with a run rate funded debt-to-EBITDA of 6.3x, while having accumulated more than $1.35 billion in unencumbered assets or approximately 35% of our undepreciated balance sheet. The expansion of our pool of unencumbered assets led us to the implementation of an unsecured credit line just over a year ago. Then, during this past quarter, we modified, extended, reduced the cost of and increase the availability on that line of credit with the help of our bank syndicate. Part of the modification was designed to enable us to issue unsecured term note offerings, should we elect to do so. With the credit facility enhancements complete, we pursued an investment-grade corporate credit rating. Today we announce that STORE has received a BBB- credit rating from Fitch Ratings. This makes STORE amongst the very few equity REITs today that have both a highly-rated debt conduit, while also being in our own right an investment-grade company. Having done this, we will proceed with an inaugural private placement issuance of unsecured term note that might be complete as soon as the fourth quarter. Here, it is important to keep in mind the aim. We remain committed to our initial master funding ABS strategy, which has been a consistent supplier of flexible and attractively priced borrowings, since we pioneered the strategy in 2005. The use of unsecured term borrowings is completed via an initial private placement offering, may not realize at the outset savings to our current A+ rated conduit. However, we do expect that having two source of investment-grade term borrowings will ultimately reduce our cost to capital, while also providing important term borrowing diversity. So our expected forthcoming unsecured term note issuance will be an important start down this path and towards the complementary commitment to an unsecured term debt borrowing strategy that will serve to greatly benefit our shareholders and customers. As I stated on our last quarterly conference call, STORE's leverage and level of unencumbered assets are highly favorable relative to a more than 20-year history of running public REITs. Likewise, our investment spread this year have been the highest, our contractual portfolio lease escalations are the highest, our portfolio diversity is the highest, our dividend payout ratio the lowest, relative to any time in our past. Add this to the opportunities we see for new investments, and we could really not be more excited about the growth path ahead of us. And on that growth note, I'd like to turn the call over to Mary Fedewa.

[Mary Fedewa:]

Thank you, Chris, and good morning, everyone. As Chris mentioned, we had another strong quarter in acquisitions, resulting from working directly with our customers, creating long-term contracts, focusing on master leases with annual escalations. And I am pleased to report that the momentum we've experienced this entire year has extended into the fourth quarter, including what we expect to close today, we have funded fairly over $1 billion in gross acquisitions year-to-date. As Chris mentioned, our lease rate for the third quarter was over 7.8%. As we've said before, this is a flow business and the lease rates can fluctuate on a quarterly basis. We still expect an overall 8% average lease rate for 2015. The properties we have acquired since September 30 and the properties currently in our closing pipeline, continue to meet our investment criteria. They are predominantly in service industries with strong STORE scores that are consistent with investment-grade tenant. Now, turning to the market. During the third quarter, cap rate compression continued in the marketplace. However, STORE's cap rate spread over the marketplace remained consistent, driven primarily by our direct origination approach and our ability to provide innovative solutions to our customers. Our pipeline of investment opportunities remains robust, as we continue to focus on generating organic growth through our brick-by-brick approach. We are excited about the final two months of 2015, and look forward to another year of strong growth ahead in 2016. With that, I'll turn the call to Cathy to talk about operating results and 2016 guidance.

[Catherine Long:]

Thank you, Mary. I'll begin my remarks today with an overview of the results of our third quarter ended September 30, 2015. Next I'll discuss our balance sheet and capital structure, followed by a discussion of our updated guidance for 2015 and the guidance we introduce today for 2016. Unless otherwise noted, all comparisons refer to year-over-year periods. So starting with the income statement. Total revenues increased 47%, $74.8 million for the quarter, primarily attributable to our continued portfolio growth, which generated additional rental revenues and interest income. This also marks an increase of 9% from last quarter's revenues of $68.9 million. As I have stated on previous calls, the timing of acquisitions during the year can have a meaningful impact on our results of operations for that year. Our record level of acquisitions volume for the first nine months of this year has driven us to outperform our revenue projections, allowing us to increase the 2015 guidance that Chris mentioned earlier on the call. By the end of our third quarter this year, we've grown our portfolio to $3.7 billion, representing 1,246 property locations, up from $2.5 billion in gross investment amount, representing 850 property locations at September 30 a year ago. This is a 47% net increase in the size of our portfolio in the past 12 months and a 33% increase in the size of our portfolio since the beginning of this year. Our portfolio's base rent and interest on an annualized basis was approximately $312 million at September 30 as compared to an annualized $238 million on the portfolio that was in place at the beginning of the year. As Chris discussed, the weighted average going in lease rate for real estate investments acquired during the third quarter was just over 7.8%, slightly lower than the 8% weighted average rate we expect for the year. Total expenses for the third quarter increased 30% to $52.4 million compared to $40.2 million a year ago. Again, most of the expense increase relates to the growth of the portfolio, with more than half of the increase in total expenses due to higher depreciation and amortization expense during the quarter. Interest expense increased about 12% to $21.4 million for the quarter from $19.1 million a year ago, primarily due to an increase in long-term borrowings used to partially fund the acquisition of properties added to our portfolio. The long-term debt we've added in the past 12 months includes the April 2015 issuance of $365 million of STORE master funding, A+ rated net leased mortgage notes, which we reported earlier this year and a minor amount of traditional mortgage debt. Interest expense was also impacted by lower weighted average interest rates on both our long-term debt and our credit facility in 2015 as compared to 2014. Property costs increased to $471,000 for the third quarter of 2015. At the end of our third quarter, we had very few properties that were not under released and we had no scheduled lease maturities through the end of next year. While we do expect to include some property level costs from time-to-time, when we have vacant or underperforming properties, we don't expect property cost to be significant. G&A expenses increased to just over $7 million for the quarter from $5 million a year ago, primarily due to the growth of our portfolio and related staff additions, along with the increase costs associated with being a public company since our IPO a year ago this month. As we continue to grow, we focus on managing our costs. Despite the addition of the regulatory and governance costs associated with being a public company, G&A expense as a percentage of portfolio assets decreased slightly from last year. Net income increased to $23 million for the quarter or $0.18 per basic and diluted share compared to $10.8 million or $0.13 per basic and diluted share for the year ago period. The increase in net income was primarily driven by the additional rental revenues and interest income, generated by the growth in our real estate investment portfolio. Our net income for the third quarter also included a gain of about $700,000 on the sale of three properties. In comparison, net income for the third quarter of 2014 included a gain of about $100,000 on the sale of two properties. AFFO increased by 66% to $48.6 million or $0.38 per basic and diluted share compared to AFFO of $29.3 million or $0.35 per basic and diluted share in the third quarter of last year. This is also a 14% increase from last quarter's AFFO of $42.8 million or $0.36 per basic and diluted share, which highlights our consistent 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 the acquisition volume and higher operating expense to support our growth. For the third quarter of 2015, we declared a regular quarterly cash dividend of $0.27 per common share to our stockholders on AFFO per share of $0.38. Our low dividend payout ratio provides a level of free cash flow that can be used for additional real estate acquisitions. The third quarter dividend was paid on October 15, and on an annualized basis represents $1.08 rate per common share, an increase of 8% over our previous annualized dividend. Now, I'll provide an update on our balance sheet and capital structure. Towards the end of the third quarter we expanded our unsecured credit facility from $300 million to $400 million, and increased the accordion feature from $200 million to $400 million for a total maximum borrowing capacity of $800 million. The amended credit facility now matures in September 2019 and includes a one-year extension option, subject to certain condition. As of September 30, we had $192 million of borrowings outstanding on this credit facility, along with a pool of unencumbered assets aggregating over $1.3 billion. As we previously reported, the credit facility bears interest at a rate that varies, depending on our overall leverage level. Based on our leverage ratio in effect as of September 30, 2015, the rate on our credit facility was one month LIBOR plus 1.35%. Our total debt outstanding at September 30 was $1.83 billion. We measure leverage using the ratio of adjusted debt-to-EBITDA. Because of our high rate of growth, we look at this ratio on a run rate basis, using estimated run rate EBITDA. Based on our real estate portfolio of $3.7 billion at September 30, we estimate that our leverage ratio on a run rate adjusted debt-to-EBITDA basis was approximately 6.3x. Going into the fourth quarter, we had unrestricted cash and cash equivalents on our balance sheet totaling $29 million and over $200 million available on our unsecured credit facility. As Chris mentioned, with our newly announced investment-grade rating, we could expect to issue our first privately placed senior unsecured note as early as the fourth quarter, the proceeds of which would be used to pay down the amounts then outstanding on our credit facility. At that point, virtually all of our borrowings would consist of long-term fixed rate debt with well laddered maturities. This is consistent with our aim to minimize our exposure to floating rate debt by minimizing the time between the acquisitions of our real estate and the ultimate financing of the real estate with long-term fixed rate debt, thereby locking in the spread for as long as is economically feasible. Now, turning to our guidance for 2015, as Chris discussed, we are raising and narrowing our AFFO per share guidance from our previous range of $1.38 to $1.42 to a new range of $1.45 to $1.47. We are increasing our acquisition volume guidance to $1.1 billion. And I should point out that this is our volume expectation, net of anticipated property sales, including sales totaling $32 million in original acquisition cost completed so far this year through yesterday. We still expect our weighted average cap rate on new acquisitions to be at about 8% for the year. And regarding leverage, we continue to target our run rate debt-to-EBITDA level of between 6x and 7x. And G&A cost are expected to be between $29 million and $30 million for 2015, including commissions and non-cash equity compensation. As we've mentioned before, we expect G&A costs as a percentage of our portfolio assets to trend lower overtime due to our scalable platform. Now, turning to our guidance for 2016. We currently expect 2016 AFFO per share of $1.59 to $1.63, based on projected annual real estate acquisition volume of approximately $750 million. As we've seen so far in 2015, AFFO per share in any period is particularly sensitive to the timing of acquisitions during that period. The timing of acquisitions for 2016 is expected to be spread throughout the year, though weighted towards the end of each quarter. Our AFFO guidance is based on a weighted average cap rate on new acquisition of 7.75%. Our AFFO per share guidance for 2016 equates to anticipated net income of $0.74 to $0.77 per share, plus $0.76 to $0.77 per share of expected real estate depreciation and amortization, plus approximately $0.09 per share related to non-cash items and real estate transaction cost. We continue to target a run rate funded debt-to-EBITDA ratio in a range of 6x to 7x or roughly 45% to 50% leverage on the gross cost of our portfolio. Interest cost on new long-term debt for 2016 is estimated based on a weighted average interest rate of 5%. And finally, G&A costs are expected to be between $32 million and $34 million for 2016, including commissions and non-cash equity compensation. This concludes my prepared remarks. And I'll now turn the call back to Chris.

[Christopher Volk:]

Thank you, Cathy. I have a few remarks to make, before turning this call over to questions. First, as always, I invite you to our website and download our packet of supplemental information, which contains market leading portfolio disclosure. Second, upon introducing STORE in the public equity markets a year ago, we are bringing forth a terrific growth company that just happens to also be a REIT. For STORE, the major portion of our growth will be delivered from external growth, which is the ability to realize AFFO per share accretion through new investments that are enabled by new equity issuances. Having seen the power of external growth over the past 30 years, we have high confidence in this dependability. What 2015 has demonstrated is the power of accelerated investment timing, which has contributed materially to our REIT AFFO per share guidance for the year. Here it bears note that with our revised guidance today, the bottom end of our 2015 AFFO per share range increased approximately 5% and the top-end of the range increased by 3.5%, which is a percentage change not far off from the annual AFFO per share growth rates for many REITs. As we look to 2016, the level of growth we realized will likewise be dependent upon the amount of our investment activities that can be accelerated to have an impact on 2016 versus 2017. But either way, external growth is a powerful and dependable force, as we've seen over many years. Now, at STORE, we've compounded this external growth with the best internal growth prospects of any net lease we have ever run. Our average annual contractual lease escalation approximates 1.7%, which is the highest of any company we have ever operated and likely stands amongst the highest of any net lease REIT. At the same time with the dividend of $0.27 per quarter, our payout ratio today stands at under 74% relative to the 2000 midpoint AFFO guidance and at approximately 67% of our 2016 midpoint AFFO guidance. This is amongst the lowest dividend payout ratios of any net lease REIT and is a lowest payout ratio we have ever experienced, since we first introduced our first public net lease company in 1994. We estimate that combining the ability to reinvest surplus cash with favorable tenant lease escalations improved internal AFFO per share growth prospects to between 3% and 4% annually. As we often say, there could be no better tonic for uncertain interest rate times then growth and a well protected dividend. And with that, I'd like to turn the call over to the operator for any questions.

[Operator:]

[Operator Instructions] Our first question comes from Vikram Malhotra of Morgan Stanley.

[Landon Park:]

This is Landon on for Vikram. I just wanted to ask about the new debt rating, and maybe how that figures into your thought process, as previously you guys had sort of indicated that the master funding conduit was pretty much sufficient for your needs? And maybe how you expect the trade off between those two resources to trend going forward?

[Christopher Volk:]

This is Chris, and I'll start, and I should also introduce or say that I'm surrounded by the full complement of our senior leadership team, so if questions moved to other people that would be great. We decided that given the level of unencumbered assets that we had, we had an opportunity to have a level of financial diversity that we didn't have before, so we obviously love and are very attached to our STORE master funding. We're one of the few net lease REITs or really any type of REIT that has multiple sources, and certainly in net lease space multiple sources of debt for the kinds of products that we do, whereas it's very easy to come in very dependent on just unsecured market as your sole vehicle. We have been able to show that the ABS space is really good and offers us a lot of the same flexibility that we would have in the unsecured debt side. But the same token in the ABS space, in terms of numbers, it's just not as big as the unsecured debt markets. So what we're doing is basically broadening our scope to include complementary unsecured offerings, so that we can basically jointly access both of these marketplace, the ABS market being one, such marketplace where we are very seasoned issuer and then the unsecured marketplace being a place where the sheer amount of volume is much greater and the level of efficiency is extremely high. And together, I think, both of those will serve to give us both capital flexibility and ability to have extremely prudent leverage strategies, and at the same time be able to lower our cost of capital relative to many companies.

[Landon Park:]

And is it safe to assume that the initial pricing will be relatively close between the two sources, but going forward the unsecured may begin to become a more attractive from the pricing standpoint?

[Christopher Volk:]

Yes, I would say, initially, it's too early to say exactly where our -- I don't want to predict today on the phone, where our initial unsecured debt transaction is going to come in at. It wouldn't be appropriate to do that. But I would say that, if it comes in higher than the ABS market, that's feasible. So this is not a contest, so we're not seeing they are trying to bench one of the other per se. But I can say over time, it bears a note, that the unsecured debt market is very efficient. So for example, if you look at a reality income who have a BBB+ rating, their rating is essentially three notches south of our A+ rating on the ABS side. And you have the cost of debt they issue on BBB+ unsecured is well inside of the ABS marketplace. So the unsecured marketplace is complementary and just highly efficient because it's so liquid.

[Landon Park:]

And will you guys be pursuing a second rating from one or the other agencies?

[Christopher Volk:]

I think over time that would be expected, yes.

[Landon Park:]

But no timeline on that when you plan to engage?

[Christopher Volk:]

No, timeline to that.

[Landon Park:]

And then just really quickly on the acquisition front, just wanted to understand the cap rate guidance for next year seems to imply a little bit of, I don't know, if its compression or is it mix that's driving that, and maybe what you're seeing in general on that front?

[Mary Fedewa:]

I would say that we have seen some compression and our spread over the marketplace, as I've mentioned, has remained consistent. Our third quarter was 783, it's not a trend, it's just a quarter, but we've seen quarter in the high-7s and I think we want to prudent and determined in thinking about next year. And I think that you may see cap rates go down a little bit more, and so we want to be -- that's where we think that where it would be prudent for us to be next year and we hope to see that.

[Christopher Volk:]

Obviously, we want to be there. And Landon, I would say, we've seen likewise for the $750 million off of acquisitions, and investors are investing in our stock, as I said in my prepared remarks, external growth is an incredibly dependable mover of AFFO per share. So then the question is how dependable is it? I think $750 million is dependable. I think for us to sit there and say, we'll do big one next year, you can't do it. We don't have visibility, we're in a flow business and we wouldn't expect to be that aggressive. If it's up to Mary, obviously we'll do more than $750 million for next year. We certainly did more than $750 million this year, we'll to have just play it by year and the lead time of these transactions is long and the size of these transactions is very small. So it's a great granular, organically driven portfolio that's just hard to get a lot of vision in November, more than a year from the estimate date.

[Operator:]

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

[Craig Mailman:]

Maybe just following up on the unsecured debts question there, and Chris your comments about the ABS market and the size, did you guys recently looked to go to the ABS market, and there was some there that you didn't see or that you didn't like?

[Christopher Volk:]

No, I mean what we're doing is, have we gone to the ABS market, we keep up with it all the time. If we want to go to the ABS market, we would have gone and we would have issued debt. So the ABS market has certainly been open. After I tell you all, the marketplace has been sort of choppy relative to the first half of the year, so second half is going to be little bit choppy, but absolutely the ABS market has been open, we could have accessed it, if we wanted to. This is something we've given a lot of thought too and it's pretty strategic.

[Craig Mailman:]

And how do you guys weigh kind of the benefits of the master funding where its asset recourse versus recourse in the pricing there versus going unsecured and kind of shifting the recourse on to you guys from the asset level versus the same as you may also to get down the line on pricing unsecured?

[Christopher Volk:]

Well, first of all from the strategic perspective, you're going to see us do several things. We have availed ourselves historically very little of the CMBS market, but we may do so from time to time if we have large discrete assets, where we want asset level recourse and we don't want to have a corporate recourse. The ABS marketplace is efficient, because it gives us 70% leverage to a single A rating. So the reason we have so much in unencumbered collateral is because the company's leverage is less than 50%, but the ABS market allows us to go to 70% to a single A+ rating, which is incredible. So it's a very efficient marketplace. So then if you layer on to that, the unsecured credit, and you say, well, what's the difference between STORE versus, let's say, some company that's just unsecured credit rated. Well, if a company is unsecured credit rated and they don't have the ABS market, obviously they can't ham and egg, they don't have two sources of capital, there's no way for them to refinance their assets other than the unsecured debt marketplace. So it's important to make that distinction. The second thing is that the ABS market and the unsecured market do not always move in tandem. And from an efficiency perspective, it is important to make that distinction. The third is that because the ABS market allow us a better leverage and more efficient leverage, then what's feasible for us is still to maintain a slightly higher leverage profile than, lets say, a REIT that's solely unsecured, and therefore not have to sort of use preferred stock or other very expensive types of leverage to be able to fund ourselves. And in doing that, we can lower our cost of capital and yet maintain an incredibly high level of unencumbered assets to unsecured debt coverage ratio and unencumbered fixed charge coverage ratio relative to anybody else. So if you think about it, if you start doing the math relative to where we're going to be, relative to other unsecured issuers, because we have master funding, it's a huge compliment to the unsecured note issuers, because it's like lending money to a pool of $1.3 billion worth of unencumbered assets and having a guarantee of $90 million for the free cash flow falling off from master funding and having a massive unencumbered asset coverage relative to a REIT that would just have solely an unsecured debt rating.

[Craig Mailman:]

And then on guidance, Cathy, can you breakdown the $0.09 between sort of non-cash G&A transaction costs and whatever other non-cash items might be in there?

[Catherine Long:]

I don't have that with me, but it's predominantly going to be the equity comp is probably the main item, and transaction cost would be very small.

[Craig Mailman:]

And then just lastly, it sounds like the pipeline is robust here. Of the $750 million you guys are putting in guidance for next year, how much of that is kind of in the pipe now that just may fall from '15 into '16 versus kind of spec opportunities you guys may need to source.

[Christopher Volk:]

I would say today it's maybe $100 million, but keep in mind that that's sort of same as last year. I mean, you always have a pipeline. We have some momentum going into the beginning of year.

[Operator:]

Our next question comes from Todd Stender of Wells Fargo.

[Todd Stender:]

Maybe to start with you, Mary, if you don't mind, you talked about investment spreads remaining wide. Is that over a blended cost of capital and does that include an equity component?

[Mary Fedewa:]

At the spread I was talking about the marketplace cap rate to our cap rate, Todd, that we remain consistent. We're still seeing substantial spread over the auction marketplace to the cap rate, we're able to create through our direct origination model, as you know, as we're calling directly on customers and creating our own contracts, we're getting a premium in the marketplace and that's the spread I was referring to.

[Todd Stender:]

Not over your cost of capital?

[Christopher Volk:]

So Todd, so think about it this way, let's say, we're 7.75% hypothetically and let's say that your cost of debt is 5%. And obviously, we'd like to be higher than 7.75%, we'd like to have our cost at lower than 5%. But you can't tell on average whether that rate is moving up. So I think if I am you, I am going to model out a 5% debt rate, why not. So basically, what you've got then is you have a 2.75% spread right to your cost of debt. Now, in addition to that, keep in mind that your lease escalators, and we didn't give you predications on lease escalators, but I would tell you that our lease escalators have been incredibly stable, since we opened our doors here, so it's around 1.7%. So you can basically take the 2.75% spread and add another 1.7% on to that for a constant growth formula to get a gross spread as it were. And if you were to assume hypothetically long run cost of equity capital for equity reinvestors, we should blow through that. I mean the amount of margin for error we have here is a lot. And it's in everything we do, it's from the way we buy assets, the deposit spread, as just Mary mentioned to the marketplace, in terms of buying assets below the replacement cost, and its is making lease rates and returns that we hope exceed our cost of capital, so we don't ever find ourselves being worth less than what we cost to create.

[Todd Stender:]

Could you guys provide an investment spread over your blended cost of capital? Do you have something that does factor in what your equity cost was?

[Christopher Volk:]

Well, look, I mean, I've seen a lot of people do issue AFFO yields before their cost of equity capital. I've never thought my AFFO yields without a cost of equity capital. So we're booking 15-year leases. I mean, our average lease term this quarter was 17 years. So you seems to asking what my cost of capital is over 17 years, I'm going to go to the entire equity markets over the 17-year period of time and say, I think it's probably 8, maybe it's 9. So you take 9 and 5, and you blend that and you see what your return is over that. And I think by the way, every RIET should do that, because you can't just look at your AFFO yield on any given day.

[Todd Stender:]

And how about just you gave us the average cap rate for the quarter, how about the range of cap rates maybe a low and a high?

[Christopher Volk:]

I'd say the range, probably the lowest will be kind of 7.30% and highest will be certainly at 8%.

[Todd Stender:]

And then you kind of touched on this, whether maybe your potential new unsecured offering would have a higher coupon than your ABS funding program. At what point do you not do the unsecured? Is there a basis point spread where you say, wait, let's just stay with our master funding program just based on coupon alone?

[Christopher Volk:]

Yes, I'm sure there is. I mean we're going decide whether we're going to hit that. But again, what you're going do is if we do a private placement deal, we're going to get the income as a private placement deal. If we do our first unsecured deal, you tend to have first issuance impact. So when we did our first master funding transaction, it came in at 595 that was in 2012. So interest rates were materially different from where they are today. I don't expect it to be anywhere near that. But I'm just pointing out to you that today and obviously for the first part of this year, our cost of master funding was 406. So you have to take the long-run view on the cost of debt capital, and today when I look at that 595 debt, it's great because when it matures, I hope I can refinance it for less. So to tell you, it's less risky for investors. And we're locking in spreads. I mean, what we didn't want to do is load up on floating rate debt, just have a bunch of unencumbered assets, so that we could wait around to maybe do an unsecured debt deal. I would rather match fund stuff at a rate where I'm giving you an honest AFFO number that's locked in -- is locked and loaded and its termed out.

[Todd Stender:]

And in match funding, would this be closer to a 10-year maturity?

[Christopher Volk:]

Yes, what we're going to do is when you say you can't match fund a REIT so -- I mean, you can't match fund any REIT, and you certainly can't match fund a net-lease REIT, because even though our lease term this quarter was 17 years, leases were invariably renewed. So what you're trying to do is match fund your cash flows. Since our payout ratio is pretty low, we're starting to have a pretty large piece of free cash flow every year, which can be affectively used to sort of payback debt, and then you're buying new assets and so you're immunizing your cash flows and you're trying to match fund your cash flow stream. So what we're doing I think at this point is filling in gaps in our maturity schedule, so that we're having a good ladder and that's just was important to us at this point.

[Todd Stender:]

And just finally, most of the REITs across all the property types that we cover are talking about increasing asset sale programs. Your disposition volumes have been fairly modest. You've got a really low payout ratio, so very well covered dividend. The asset pricing is favorable. How you're looking at asset sales, I guess maybe in the near term and maybe in the next year as you look at your budget?

[Christopher Volk:]

In terms of where we're priced today, we're priced at or above where we could sell the assets. So let's say, it's a push. It's just not really worth for us to sell a bunch of assets today. I think that it's a long run for a short jump for you guys, and it's not going to do our shareholders the best good. I mean, creating a diversified portfolio just has way more values. So when we're selling off assets, it's going to average 1% to 1.5% of the portfolio every year. So Cathy is giving the estimates for next year, it's a net number and we're assuming we're going to sell off 1% to 1.5% of portfolio. The 1% to 1.5% of portfolio we sell would be view on our strategic holdings and what we'd like to keep over a long term and what we're willing to part with. It's not an effort for us to just maximize gains and flip out assets. It's a very strategic thought process. It happens every single month at our asset management portfolio meeting and we just go through this stuff. And as I said on the call earlier, the fact is that we've been generating gains on this, which isn't surprising, because we're booking assets, as Mary noted above, that broader auction marketplace, so there's room in there to be able to book some gains. And the gains, we don't get any credit for them from an AFFO perspective, but they're sort of a like negative default rate. And I think so that you can get the gains and so they help to lessen portfolio of volatility and that's how we look at it.

[Operator:]

Our next question comes from [Indiscernible] of SunTrust.

[Unidentified Analyst:]

My first question is this past quarter you didn't disclose the expected default frequency. Should we expect that to be similar to the prior quarter?

[Christopher Volk:]

I saw that [ph] Ketan had had that on his deal this morning. And I was thinking okay, I am going to get asked this question. So every quarter we're going to modify our disclosure, and generally we've had a disclosure, so we haven't reduced disclosure, but when you get into the expected default rate and numbers and you get into the number of 0.87 or some decimal point, it sounds so precise and it just bothered me. And when you talk about the percentage of portfolio, its investment grade, last quarter it surely was 78% investment grade of 78 point something, it might had decimal point. And even on the quarterly slides, if you looked at our quarterly investor presentation, I've always said, its approximately three quarters or approximately 75% of the portfolio, because if you're doing this, when you run the financial statements, the financial statement through Moody's RiskCalc, its incredibly volatile. You can move from quarter-to-quarter. We have tenants moving in and out of investment grade, ratings or in and out from BA2 to BA1 or BA2 to BA3. And so I tend to sort of take the long run approach on the stuff, and I didn't want people who sit there and like go, okay, this moved down 10 picks, so should I be worried. So the answer is about three quarter of our portfolio is still investment grade. We had a slight gravitation downward from investment grade status versus last quarter. And big chunk of that is attributable to the methodology with which we're calculating it, some related to a couple of speed bumps that couple of our customers had, but those are not speeds bumps that we worry about. So we're here three quarters and the portfolio is doing fine.

[Unidentified Analyst:]

So it's safe to assume it hasn't materially changed then. Is that correct?

[Christopher Volk:]

No.

[Unidentified Analyst:]

And then my second question is do you have sense of Oaktree's plans on selling part of their stake either next quarter or next year?

[Christopher Volk:]

I don't. All I will say to is that Oaktree will subordinate their need, and they don't really have a need to sell. So that need is very long worth. So it will subordinate any desire they have to sell or thought they had to sell to our desire to grow. As long as we can grow accretively, which we certainly have been able to do that on an AFFO per share basis. So if you're looking at roughly a 10% AFFO per share growth at the midpoint for next year, that's something that I think Oaktree is really encouraged by. I think that like any other private equity holder, they will look to exit out overtime. But I think that they will incredibly disciplined about it, and they will do it in concert with us. And further, I can't give you any guidance.

[Operator:]

Our next question comes from Paul Adornato of BMO Capital Markets.

[Paul Adornato:]

I was wanted to ask about the third quarter activity as well as looking forward to the pipeline for 2015 in terms of the mix of acquisitions. You typically say, about 80% is directly sourced versus 20% out in the market. Is that what happened in the third quarter? And what's the outlook for next year?

[Mary Fedewa:]

And that's exactly what happened. Same outlook for next year.

[Paul Adornato:]

And what are you seeing in terms of behavior of your customers? Any change based on their outlook for the macro economy? And what sectors are hot or not at this point?

[Mary Fedewa:]

So to answer your first question on interest rates and the macro economy and so forth, no, we haven't seen much change with the customers. There will be a very long-term lag for us, as interest rates do move around with our customers. And remember, we're out there creating contracts and creating business with our customers. So we have the opportunity to ask for the cap rate and ask to get paid for the value we're adding. So from that perspective, we will continue to do that. And your second part of your question again, sorry.

[Paul Adornato:]

Which sectors are hot?

[Mary Fedewa:]

Sector that's hot, so that's an interesting question, because we're financing profit center real estate, we have the opportunity to look at all sectors, Paul, and look at all industries that have profit center real estate, and that's what we're interested in. So we are not sector specific and we're not moving into different sectors. We're looking at a global profit center interest or profit center real estate.

[Christopher Volk:]

So I wish we were big enough to be statistically significant, but I mean going $300 million and $400 million worth of stuff in a quarter, you can't really make any heads or tails out of any macro moves by sector, and this quarter we were obviously involved with a lot of different industries. And frankly, most of the industries that we do and most the tenants that we have aren't going gangbusters topline. I mean the coverage tend to be sort of stable, they tend to gravitate towards around the middle. We have not been making this with any assumption that the economy is going to catch fire or that there is any hot sector. And also to be honest, we stay away from some of the hot sectors, because the hottest sectors are the ones that have the most risky tenant to them, because you have fewer players and less competitive maturity out there. So we tend to do fairly seasoned industries with company's that have been in there for a long time and lots of them.

[Paul Adornato:]

And just one more, I think FASB approved changes in lease accounting. I was wondering, if you think this might impact at all the net lease or sale lease back to markets?

[Christopher Volk:]

So the answer to that is, the short answer is no, because the lease is not a debt substitute, it never has been a debt substitute. So if you look at anything that's on our website or anything we've written about or any sales presentations we've made, whether something is on balance sheet or off balance sheet is kind of irrelevant to us, because what you're doing is you're giving somebody a form of capital, but has a lower payment constant than any other long-term capital. It has a tendency to be more flexible than any other long-term source of capital. And it tends to be a substitute for both debt that they would otherwise have to take from a financial institution and the equity they would have to deploy, which comes at a higher cost. So that is how this is sold. Now when you change the accounting rule, which have been debated --

[Mary Fedewa:]

Years?

[Christopher Volk:]

Yes, like last decade or something like that.

[Mary Fedewa:]

Yes, maybe more.

[Christopher Volk:]

And you're an analyst, Paul, so I would say that I don't think that the current lease accounting is perfect, but I find that the current lease accounting is very understandable, because when you read the financial statements of any company, you can see on the back, in the footnotes, exactly what their lease obligations are. And you know, as an account, for example, if a movie theater company leases all their real estate or if an airplane company leases all of its planes, it will continue to lease real estate and continue to lease planes long after those leases mature. So the notion of present valuing individual contracts is kind of a ridiculous notion, because it doesn't really come into play in terms of what the long-term results are likely to be for the company. So I think that the current lease accounting while imperfect, I tend to like it, because I can look at it and say, here's a charge to expenses, this is the charge and that charge is probably going to keep on happening for a long time irrespective of when the leases mature, because they're going to get new assets, new airplanes to lease or they're going to get new movie theaters to put on. If you make these changes, what's going to happen is it's going to put into play a lot of judgment on the part of the auditors and perhaps other valuation professionals where they're going to have to discount back present values and they're going to debate how much of that lease stream is equity versus how much of it is debt substitute, right. So this is what comes into play is to how much you actually capitalize. And so what will happen potentially is there will be greater demand for things like tenant purchase options, which today tenants don't get purchase options, because it's viewed as continuing involvement under net leases, so it would be a non-balance sheet transaction with a purchase option. So if you look to us for our first public company at FFCA and when FAS 13 was still in effect, but FAS 98 was not there yet, we were able to get our purchase options like water, not that many people took them, but we gave them out. Today, we give our purchase options very little. I think if the lease accounting changes that will happen. There maybe a greater push to shorter-term leases, because if people are having to capitalize the lease obligation, then there will be sort of an incentive on the part of accounts and company's management to want to have a present value as little of that they can. So if you get somebody a $1 million rather than capitalizing $800,000 debt, they would rather capitalized $500,000. So there will be more frictional discussions about that, which may also take place. So accounting shouldn't drive finance, but it does a little bit and it does today, in FAS 13 it does a little bit and it will do if they change it. One last comment, Paul, is that you may have companies that today like the McDonalds, for example, didn't say they would spend their real estate, but hypothetically if everybody has to capitalize leases anyway, today they can't actually do lease backs and sublease to their tenants, because it would be continuing involvement. If they changed the accounting rules, they'll be tempted to potentially do lease backs on all their properties, because they'll get big proceeds and it might be efficient, and today that would be sort of off the table. So there would be interesting things that could happen.

[Operator:]

Seeing no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to Chris Volk for any closing remarks. End of Q&A

[Christopher Volk:]

I have nothing further to add, but thank you very much for joining us. We look forward to our next quarterly conference call. And for those of you who are going to be NAREIT next week, we look forward to seeing you. So thank you very much. Bye, bye.

[Operator:]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a good day.