And if it only creates 100 basis points, we believe that on a risk-adjusted return basis, that is the right profile for that investment, we are comfortable doing that particular investment. But then we will always try to balance it with transactions that have a 200 basis point profile. But that volatility or that spectrum of spreads in this volatile environment is very difficult to predict, which is why we are — we’ve come out with the plan that we have, which — even in this environment, we can still deliver north of 10% without having to rely on the acquisition market.
Haendel St. Juste: I appreciate that. I just want to be clear, it sounds like 200 basis points is not the absolute minimum that you’re seeking, which I think is a little different for what I think we had talked about a few months ago. But my next question, I guess, is on what’s embedded in the guide here regarding credit loss and the integration of the Spirit portfolio? Can you touch on that a little bit?
Sumit Roy: The integration is going very well. We’ve closed on the transaction on the 23. We are still very excited about the portfolio we’ve absorbed. As part of this transaction, we’ve hired eight people from Spirit on a permanent basis. And we have seven people on a temporary basis that are helping us through the integration process over the next six to nine months. In terms of the actual portfolio itself, we have not been surprised by — now that we control this asset and the portfolio of clients that we are exposed to, we have not been negatively surprised on any front. There have been some positive surprises in terms of resolutions to certain clients where the outcome has been slightly more positive. But I will caution and say that it is still too early to tell.
And that is part of the reason why we were very conservative in our underwriting. And what we shared with the market, we felt very comfortable in terms of delivering. But we’ve also said that it was conservative, and there happens to be upside, which we hope plays out. And if that’s the case, we will share that information with you down the road.
Haendel St. Juste: Got it. But are you able to quantify within the guide for potential credit loss or any added color on that?
Sumit Roy: What we can share with you, Haendel, is the range that we have shared with you accommodates for any level of credit loss that the Spirit portfolio and/or our portfolio would generate.
Operator: And our next question comes from Spenser Allaway with Green Street Advisors.
Spenser Allaway: Given the dearth of deal volume right now, especially compared to recent years, what is the highest and best use of time right now? So I know you have a massive portfolio but outside of routine asset management, I’m just curious at this quiet period, if you will, is a good opportunity to underwrite new geographies or property types?
Sumit Roy: It’s all of those things, Spenser. I mean — I think you’ve been following us for a while. We are constantly looking for ways to grow our portfolio and we are constantly looking at non-traditional ways to growing our earnings. And that will continue to be a massive focus of ours in 2024. You’re absolutely right, part of having to absorb an additional 2,000 assets with 400 new clients, not all new clients, but 400 clients coming from Spirit. There’s going to be a fair amount of asset and capital recycling that we would like to also engage in and that is something that the team is very much focused on, trying to take advantage of the time that we have to focus on playing a little bit of defense rather than the offense.
But having said all of that, I do believe that this acquisitions environment can change and can change very quickly. And so the rest of the team, the investment team continues to stay in front of the clients, continues to have conversations, continues to be creative about how we could potentially be a solution to our clients. And so despite the guidance of $2 billion, I can tell you there is going to be a lot of work, perhaps even more so this year than last year in terms of creating the right tools, creating the right efficiencies, all of the things that we’ve sort of had to put a little bit on the back burner given the robustness of the investment environment that we’ve had over the last three years. So I think all of that will manifest itself in a much more scalable business, and we’ll be happy to share some of that as and when we put it to use and actually start to realize some of the scale benefits.
Spenser Allaway: Okay. Great. And do you guys have a target date for when you’d like to get through the kind of the Spirit portfolio in terms of pegging some potential disposition candidates and things of that nature? Do you guys have a target date when you want to get to the portfolio?
Sumit Roy: We are not waiting on a particular date. There’s obviously a priority of assets that we have identified that we don’t believe to be core to our overall portfolio. Those are already in the market. And then we are culling through the rest of the portfolio to continue to add to our capital recycling program for 2024. So there isn’t a particular target date, but we’ll be happy to share with you more on this front during the first quarter earnings when we’ll have assumed control of this portfolio for about 2 months and 10 days.
Operator: Our next question comes from Smedes Rose with Citi.
Smedes Rose: I wanted to go back to something you mentioned in your opening remarks where you were talking about being able to put in more growth opportunities into your leases? I think you mentioned it’s up 50 basis points versus five years ago. And as you speak to, I guess my question is, I’m wondering, does the quality or sort of the credit quality of the client vary by the ability to push through higher escalators? It sort of feels like the higher quality or higher credit would have more bargaining power on their side to resist those kinds of changes. But I’d just be interested in kind of if you could just maybe talk about that a little more.
Sumit Roy: Sure. Smedes, your intuition is accurate. In the retail space here in the U.S., when you start to talk to investment-grade clients on the retail side, on retail boxes, that enter into long-term leases, et cetera, it is very difficult to get them to give you what one would consider to be market growth rates. And so it’s the ones that tend to be BBB, BBB minus and sub-investment grade. Those are the clients that you can help drive internal growth. But let me be very clear that the 50 basis points of increase was not by going lower in the credit cycle on the retail side, but was expanding into other asset types which have a different growth profile than what retail assets do. So what were some of the steps that we took?
We obviously went into industrial in a big way. Industrials tend to have, even with investment-grade clients. And at one point, I think virtually all of our clients were investment grade on the industrial side. That’s no longer the case as we’ve matured as a company. But they too tended to give 2%, 2.5% growth. So that was one of the drivers of the change in the growth profile. The second was going into new asset types like data centers, like gaming. Those do also tend to have higher internal growth profile. And the biggest driver of all of this is really the international business where we do find a lot of growth even on the retail side with investment-grade clients. So you might recall that we had — our first transaction was a $0.5 billion sale leaseback with one of the largest grocers in the UK, and that had a growth profile that far superseded the profile that one can get here in the U.S. So it’s a combination of all of these factors, different asset types, international, which has allowed us to grow our internal growth from approximately 1% to approximately 1.5%, and that will continue to be a major focus of our business is to how do we take this profile and grow it by another 50 basis points, perhaps more so that this reliance on external acquisitions continues to be minimized.
Smedes Rose: Okay. That’s super helpful. And then I just wanted to quickly ask you. I think you kind of touched on this, but you said you’re going to recycle capital, more than $160 million that you did in 2023. And that’s just because you probably have sort of more non-core assets identified with the Spirit acquisition. So that would — that’s what’s sort of taking that number up maybe relative to where it’s been historically here?
Sumit Roy: Yes. I think one of our comments was that you should expect to see a higher number than the $116 million that we accomplished in 2023. As to the actual number, we will be in a position to share that with you during our first quarter earnings call in May.
Operator: And our next question comes from Eric Borden with BMO Capital Markets.
Eric Borden: I’m just curious if you could talk about the potential opportunities you’re seeing today as it relates to the credit lending platform. And what are the different types of tenant credit in industries that you’re targeting today?
Sumit Roy: So Eric, the way we think about the credit business is how can we be a one-stop shop for our clients. Clients with whom we’ve done traditional sale-leaseback business, that have a need to continue to grow their real estate portfolio. And if there is a disconnect, which we kind of saw last year where what you could get in terms of a sale leaseback in terms of yields versus playing in a much more secured position on a balance sheet and yet get 300, maybe even more basis points of yield on investments, it’s a win-win for us as well as for our clients. And they would much rather do business with somebody that they understand and that they have a relationship with, and we can offer more of these products to them and enhance the economics on our transactions.
That’s really what’s going to drive the credit side of our business. Having said that, it’s across the board. I think we’ve talked about doing a credit investment in the gaming side with Blackstone. We’ve talked about doing an investment on one of the largest grocers in the UK. Again, these are the types of examples that you should continue to see. But we are going to be very selective in terms of who we lend to, given that, that is not a core element of our business.
Eric Borden: That’s helpful. And then I just wanted to ask one question on the free cash flow. On the $800 million plus of expected free cash flow for 2024, does that guidance include the potential income generated from holding cash in a money market account?
Jonathan Pong: Eric, it includes everything. So in our AFFO guidance, first of all, all of those outcomes, if we’re sitting on cash like we have been, where we’re relentless and trying to get as much as we possibly can while it’s there. That flows through to FFO. And then you have to deduct obviously, for the dividend, that in effect is the free cash flow.
Operator: And our next question today comes from Linda Tsai with Jefferies.
Linda Tsai: Can you just take us through some puts and takes regarding the high and low end of your AFFO per share guidance?
Jonathan Pong: Linda, so on the low end at 413, it’s a fairly draconian scenario. You almost have to believe that short-term rates are going to continue to push higher, which we have — we don’t have a crystal ball, but crazy things have happened. It also assumes that there’s essentially a shutdown of acquisitions and so you can assume that the $2 billion is something significantly less than that. From the credit loss perspective, I think that’s also something that we put in a very, very conservative number that we don’t think is likely at all of happening, but it is something that is included from a bad debt perspective. There’s also some certain cost elements, things like leasing commissions, things like property expenses that are not reimbursed in G&A.
You always want to plan for some negative surprises there. And then in terms of the high end, it contemplates a scenario where the macro environment and the cost of capital environment improves, and we are able to do quite a bit more in terms of investment volume. It also suggests that spreads stay in that 150 and up range. Bad debt expense is something that is closer aligned to where we historically have been as a company, which has been close to 40 basis points of rent when you include the pandemic. Outside of the pandemic, we’re probably closer to 25 basis points. And it probably would assume a better outcome for some identified credits that we have in the combined portfolio that naturally, we took a very, very draconian stance on as we’re building up the base case for guidance.
And it also assumes that the mix of our short-term rates, whether it’s in euro commercial paper, whether it’s in sterling denominated revolver borrowings or whether it’s in USCP, which tends to comprise of every exposure, it assumes that the mix is tilted maybe a little bit more towards the European side. Right now, indicative ECP rates would be in the low 4% range. U.S. indicative rates would be in the mid-5s and then you have sterling at 6%, not on the CP side, but on the revolver side. So these are all the variables that have to hit on the low and high end in order for us to reach those scenarios.
Linda Tsai: Really helpful. And then just my second question is in your pipeline right now, what percentage is domestic versus international?
Sumit Roy: Well, we don’t have — it’s unidentified on the non-development side, which was $1.2 billion. Some of it is identified, but a lot of it is discussions that we’re having both here in the U.S. and in the international markets. And if you look at what we did last year, 35% of everything we did was in the international market, 65% was here locally. That could change because it is such a small number. Based on the discussions today, there could be a lot more on the international side than here, but it’s too early to tell, Linda. If you look at the history, it’s largely been in that 30% to 40% international and 70% to 60%, 60% to 70% U.S. And that’s what we would expect under normalized situation.
Operator: And our next question comes from Alec Feygin with Baird.
Alec Feygin: So I have one on income taxes. So for the full year, the year-over-year increase in 2023 was about 15%. And the midpoint of guidance is implying about a 35% year-over-year increase in 2024. Can you provide some more color on what is driving that large increase in income taxes?
Jonathan Pong: Alec, this is really a function of the international business. So the way that we’re taxed on that income, it’s primarily in the UK. First of all, as a U.S. domiciled company as the 100% owner of the UK, but we are subject to some withholding taxes there. Now what we’ve done to combat that is we have intercompany loan interest expense and other ways that we can lower taxable income, where the effective tax rate on that NOI is around 11%. But the growth that you see year-over-year is really just a function of the growing platform and portfolio that we have abroad, which is now north of $9 billion. So it shouldn’t be a surprise that as the UK grows in particular, you see that line item for income tax start to increase year-over-year.
It’s something that we obviously take into account in our underwriting and investment committee. It’s a factor, obviously, in our long-term IRR underwriting, which is really what dictates the investment decision in most cases. And so it’s a known cost that is fully built in to this business model.
Operator: Thank you. This concludes the question-and-answer session. I’d like to turn the conference back over to Sumit Roy for any closing remarks.
Sumit Roy: Thank you all for joining us today. We look forward to seeing many of you at upcoming investor conferences in the Spain. Thanks. Bye.
Operator: Thank you, sir. This concludes today’s conference call. We thank you all for attending today’s presentation. You may now disconnect your lines, and have a wonderful day.
