Healthcare Realty Trust Incorporated
Q2 2017 Earnings Call Transcript

Published: 6 Aug 2017

[Operator:]

Good day, and welcome to the Healthcare Realty Trust Second Quarter Analyst Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Mr. Todd Meredith, President and CEO. Please go ahead.

[Todd Meredith:]

Thank you, Allison. Joining on the call today are Kris Douglas, Rob Hull, Doug Whitman, Carla Baca and Bethany Mancini. Miss Baca will now read the disclaimer.

[Carla Baca:]

Except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risks and uncertainties. These risks are more specifically discussed in our Form 10-K filed with the SEC for the year ended December 31, 2016 and then subsequently filed Form 10-Q. These forward-looking statements represent the company's judgment as of the date of this call. The company disclaims any obligation to update this forward-looking material. The matters discussed in this call may also contain certain non-GAAP financial measures such as funds from operations, FFO, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, FAD, FAD per share, net operating income, NOI, EBITDA and adjusted EBITDA. A reconciliation of these measures to the most comparable GAAP financial measures may be found on the company's earnings press release for the second quarter ended June 30, 2017. The company's earnings press release, supplemental information, Forms 10-Q and 10-K are available on the company's website. Todd?

[Todd Meredith:]

Thank you, Carla. Healthcare Realty's portfolio continues to generate solid performance. Total same store NOI growth for the second quarter totaled just under 4%; 5% for the multi-tenant properties, driven by strong tenant retention, positive absorption and high single digit cash leasing spreads that handily outpaced average in-place bumps, well beyond what most expect and demonstrating what is possible with the portfolio built around the propensity for top line growth. Hospital fundamentals continue to look stable with outpatient utilization on the rise. Health systems and physicians continue to ramp up outpatient infrastructure, often partnering to meet demand, lower delivery costs and grow market share. While a lot of new capital and development supply are chasing riskier off-campus -- the riskier off-campus setting, we remain committed to on-campus investments with top health system where barriers to entry are high, fungibility is low and rent growth is more secure. There's also less reimbursement risk when services are delivered on the hospital campus. The Center for Medicare and Medicaid Services, CMS, continues to tweak reimbursement and correct unintended consequences of evolving Medicare policy. Section 603, the ruling that requires CMS to reduce hospital outpatient rates for services delivered in off-campus MOBs to be more in line with comparable services provided in physician offices, is a prime example of how the agency must continuously close loopholes and correct payment policy further illustrating the riskier off-campus MOBs that are dependent on the claim that grandfathered hospital services are more likely to renew expiring leases to protect their higher reimbursement levels, when in reality, it could become even more difficult to replace these higher billing hospital tenants at comparable lease rates if they vacate their space. Amid sometimes vague reimbursement guidelines and changing payment patterns, we have centered Healthcare Realty's strategic focus and disciplined criteria at the sweet spot of healthcare real estate, the intersection of outpatient growth and on-campus safety. While interest and investment is certainly heightened in MOB sector from both public and private investors, much of it is not discerning. Pricing is competitive across the spectrum, especially at the high end of quality and scale, making discipline critical. Sticking to well-designed investment criteria is strategically paramount. One of the most important criteria in our investment decisions, internal growth potential is also the lens through which we view the value of external growth. To give you a glimpse, we assigned fungibility scores to our properties based on propensity for rent growth and competitive strength, 10 being the best and 1 the worst. Our current MOB portfolio scores a 7.5 weighted by square feet, up from 6.8 a few years ago. We score every property under consideration for acquisition or development. 2/3 of available properties are off-campus and did not score well, and as a result, are not of much interest to us. Larger portfolios are typically riddled with too many low-scoring properties. Individual properties or small portfolios are more likely to score high with 8 to 10 being rare, and development being an excellent channel to own the highest-scoring properties. In the current pricing environment, we are being selective, only purchasing properties that truly measure out, that have the potential for higher growth year-after-year, delivering the power of compounding with minimal risk. Looking ahead with low leverage, Healthcare Realty is well-positioned to fund new investments and capitalize on a positive demand for outpatient facilities. Most investors know Healthcare Realty well for being disciplined, squarely focused on low-risk internal growth, and only developing or acquiring properties when our competitive advantage can be extended where we see the ability to accelerate internal growth. We remain sober about the trade-off between volume and quality, placing more value on expanding the internal growth potential and safety of our cash flows than chasing external growth for the sake of size. Now I'll turn it over to Miss Mancini to share some perspectives on current healthcare policy. Bethany?

[Bethany Mancini:]

After Senate Republicans lost their third vote last week to repeal and replace the Affordable Care Act, leaders in Congress are now promising bipartisan legislation to shore up the problematic insurance exchanges upon their return in September, when insurance companies must decide their plans and rate increases for 2018. While some legislators will be taking over federal cautious subsidies for low-income enrollees as a bipartisan near-term fix to ObamaCare, others view the funding as the government bailout and chances are slim that representative Ryan would bring such a bill to the House. Congress also needs to deal with other significant items on the agenda like the debt ceiling, defense spending, tax reform in the budget with the possibility of some healthcare issues to resurface. As Republicans have struggled to rally their members in Congress, it remains doubtful that a repeal of ObamaCare will be taken up again in the fall, much less in 2018 and election year. Medicaid expansion should continue for the foreseeable future leaving healthcare providers relatively unaffected and providing some measure of clarity on the issue. Focus will likely shift from Congress to the Trump administration as they implement their own reforms to the ObamaCare exchanges or possibly attempt to defund subsidies. Measures concerning enrollment periods, preexisting conditions and other regulatory items could be addressed hopefully for the better as there is some agreement that market-driven reforms are needed to improve the exchanges, and lessen the burden of over 1,400 rules that currently govern insurers and providers. Despite the pressure of headlines and sensitive debate over the 12 million exchange enrollees, these patients amount to only a small percentage of hospital and physician revenues, more in practices serving safety net hospitals in lower income urban and rural populations, and fewer in growing demographic areas, and practices affiliated with market dominant health systems. Leader health systems nor physicians have been considerable beneficiaries of the insurance exchanges. Providers have been relatively quiet on the issue, instead working to lower the cost of medical care and improve profit margins. Outpatient service expansion is playing an important role in lowering healthcare costs with providers taking advantage of reimbursement incentives for quality and saving. In 2016, not-for-profit hospitals saw outpatient surgeries grow by 4.6% and outpatient visits rise by 5% compared to the prior year. As Todd mentioned, the CMS continues to address reimbursement rates for off-campus hospital outpatient services with newer hospital leases. Called for under Section 603 of the Bipartisan Budget Bill of 2015, the CMS is taxed with determining a site neutral Medicare adjustment to bring hospitals' higher rate in line with physician fee schedule rates for the same outpatient services delivered in off-campus settings. First implemented this year the adjustment was largely a nonissue for hospitals, although CMS recently determined that it did not reach the goal and has proposed a higher adjustment in 2018 to better equate payments with physicians. Some off-campus hospital outpatient departments are already billing under the physician fee schedule, a trend that may continue in order to avoid the 603 methodology and the yearly adjustments and to be more competitive with other lower cost providers. Hospital leases and medical office facilities located more than 250 yards from a hospital, comprised only 10% of Healthcare Realty's portfolio most of which were in place prior to November 2015 and would qualify for the higher grandfathered hospital rate. Based on our conversations with tenants, we estimate approximately half of these tenants are already billing at the lower Medicare physician rate. While 603 might lean into a greater propensity to renew leases for some tenant, the eventual need to backfill space at comparable lease rates increases the risk profile of our off-campus facilities. In contrast, outpatient services located in MOBs on hospital campuses has benefited from stability over the years connected to the core of patient care delivery, a strategic position for both physicians and hospital services. We believe it is Healthcare Realty's commitment to investing on the campuses of market-leading health systems that continue to support strong tenant retention across the portfolio, high-leasing spreads, internal growth and longevity.

[Todd Meredith:]

Thank you Bethany. Now, Mr. Hull will provide an overview of our investment activity. Rob?

[Robert Hull:]

We are pleased with the caliber of investments completed so far this year. Since the end of the first quarter, the company has purchased three MOBs for $67.1 million with a combined expected first-year yield of 5.3%. The first is a 76,000 square foot MOB located in the San Francisco area on Sutter Health's Santa Rosa Regional Hospital campus. This is the only MOB on the campus and is 100% leased. AA minus rated Sutter Health has 29 hospitals in Northern California and is a Top 15 health system nationally by total revenue. In the Washington DC area, the company purchased a 62,000 square foot MOB that is fully integrated into AA minus Trinity Health's Holy Cross Hospital. Physicians, patients and visitors can walk a short distance between the MOB and the hospital hardly aware of where one begins and the other ends. The property is 100% leased and a purchase price of $24 million is expected to generate the first-year yield of 5.4%. Our most recent investment closed earlier this week is a 43,000 square foot MOB in Los Angeles purchased for $16.3 million. This property is our second on HCA's West Hills Hospital campus and at 93% leased, is expected to produce a first-yield at 5.4%. With the robust pipeline, we expect the majority of additional acquisitions to occur in the fourth quarter, bringing us to our targeted guidance of $175 million to $225 million. Despite some low cap rates on recent large portfolios, we continue to see individual assets trade in the 5 1/4% to 6% range with a few instances where prices have fallen into low 5%s. Development and redevelopment remains an area of focus for us as well. Many of the properties we view is the highest quality [indiscernible] making development and attractive path to earning the very best assets, while generating favorable risk adjusted returns. In Denver the company's third development on CHI's St. Anthony Hospital campus, a 100,000 square foot MOB was completed and placed in service at the end of June; the first tenant, a 13,000 square foot hospital surgery center that's scheduled for occupancy this month, followed a couple of months later by a 16,000 square foot sports medicine practice. The balance of our initial leasing is expected to take occupancy in the first quarter of 2018. Prospective tenants with which we are in ongoing dialog total 50,000 square feet and are made up of various hospital and third party groups that should take the billing to over 85% leased in the coming quarters with occupancy occurring over the next 12 months to 24 months. In Seattle, we continue to work with the hospital to program and design a new surgery center and Cancer Center, which make up 60% of the 151,000 square foot MOB development on UW Medicine's Valley Medical Center campus. Construction will commence in December with completion expected in the first quarter of 2019. As health systems look to increase their outpatient services, redevelopment of existing assets remains an efficient means of meeting a growing health systems need for space, and a compelling method to deploy additional capital in familiar markets for favorable risk adjusted returns. In Charlotte, construction is underway on a 38,000 square foot addition to an existing asset on Carolinas Healthcare System's university campus. Programing for the tenants expansion space has begun and construction is scheduled to be completed in the first quarter of 2019. The project is 85% leased and will produce an incremental return of over 7% once stabilized. At our national redevelopment, a large oncology tenant recently took occupancy in the expansion space. Over the next 3 quarters to 4 quarters, we will see the building reach stabilized NOI as new and relocated tenants finish construction of their space and begin paying rent. Going forward, our development and redevelopment pipeline remains active with new opportunities over the next few years, representing $50 million to $100 million of development starts per year. While a significant amount of outpatient facility development is occurring off-campus, our focus remains on those low-risk opportunities located on the campuses of leading health systems in markets where we have experienced and proven performance. Turning to dispositions for the quarter, the company sold 3 buildings for $38.2 million at a combined cap rate of 6.7%, including an inpatient rehab facility previously announced for $14.5 million. With these sales, dispositions for the year totaled $120.2 million at a blended cap rate of 7.1%. With our disposition efforts largely completed for the year our revised 2017 guidances is $120 million to $125 million at cap rates between 7% and 7 1/4%. I'm pleased with the discipline our team has demonstrated by selectively selling assets that no longer meet our investment criteria and rotating into properties that have a higher propensity for sustainable growth.

[Todd Meredith:]

Thank you Rob. Now, Mr. Douglas will provide a summary of financial and operational results. Chris?

[Christopher Douglas:]

Normalized FFO increased 2.8% over second quarter 2016, up to $45.3 million or $0.39 per share. As Rob mentioned, we continue to make progress in redeploying proceeds from recent dispositions. The front loading of dispositions in 2017 combined with the sale of 3 inpatient rehabilitation properties late in December 2016 resulted in temporary dilution of approximately $0.01 per share in the first quarter and $0.02 per share in the second quarter. The $0.02 of dilution will continue and into the third quarter, but will reverse once sale proceeds are fully redeployed which is expected to occur in the fourth quarter. The permanent dilution of selling almost $200 million of primarily non-MOBs in the low 7s% and reinvesting into on-campus multi-tenant MOBs in the low to mid 5%s is approximately $1 million per quarter. But in our view it additive to MOB and improves long-term growth and value. Total same store NOI for the trailing 12 months increased 3.9%, driven by a 5% increase in same store multi-tenant NOI and a 0.2% decrease in same store single tenant NOI. As in the first quarter, single tenant NOI growth was moderated by the following 2 items without which NOI would have increased by 2%. First in 2 situations in the last year, we agreed to restructure leases for increased term and improved credit. Second a portion of the single tenant net leased properties have nonannual rent increases and have not experienced a rent increase in the last 24 months. The single tenant NOI growth will begin to revert to more normal levels in the fourth quarter as 2 sizable single tenant leases with nonannual rent increases will experience escalations above 5%. In our multitenant portfolio, same store revenue increased 3.5%, which coupled with a modest operating expense increase of 1.3%, produced operating leverage leading to NOI growth of 5%. The revenue growth was driven by a combination of a 2.8% increase in revenue per occupied square foot and a 60 basis point increase in average occupancy. 3 legacy property operating agreements expired in the past year and are currently weighing on same store growth for the multitenant properties. Excluding the impact of these agreements, revenue per occupied square foot was up 3.4% and multitenant NOI grew 6.4%. The effects of these expirations will be most pronounced in third quarter and will begin to dissipate thereafter. Several metrics for the second quarter indicate that multitenant portfolio is well positioned for strong revenue growth in the quarters ahead. First, sequential occupancy increased 30 basis points through tenant retention of 90% and 86,000 square feet of new or expansion space, resulting in 42,000 square feet of net absorption. Second, while in-place contractual rent increases for the multitenant portfolio averaged 2.7% over the past 12 months, future contractual rent increases for the leases commencing in the quarter are 3.3%. Third, cash leasing spreads were 9.5% for the 285,000 square feet of renewals executed in the quarter. There were no negative spreads and 62% of the renewed space had spreads equal to or greater than 4%. Overall cash leasing spreads benefited from 27,000 square feet of renewals at our Nashville redevelopment and a 9,000 square foot renewal in San Antonio with a 40 % cash leasing spread, but no additional escalators over the 5-year term. Excluding these items, cash leasing spreads were 7.1%. These notable leasing results evidence the quality of our portfolio and benefited from an outsized proportion of renewals at properties with superior fungibility scores. Although the proportion of buildings with fungibility ratings of 9 or 10 composes approximately 1/3 of our portfolio, nearly half of the renewals in the quarter occurred at these properties. This underscores our experience that the highest quality on-campus MOBs produce higher cash leasing spreads than what many have come to expect from MOBs in general. Moving forward with a healthy balance sheet, we're poised to seize future investment of opportunities that meet our standards. Debt to EBITDA at the end of the quarter was 4.9x, which provides multiple funding sources as we continue our focus on acquiring MOBs, that are as our results demonstrate generate strong and steady growth.

[Todd Meredith:]

Thank you, Chris. Operator, that concludes our prepared remarks. We're ready to begin the question-and-answer period.

[Operator:]

[Operator Instructions]. Our first question will come from Chad Vanacore with Stifel. Please go ahead.

[Chad Vanacore:]

So I'm going to actually have a few modeling questions, really asking you about development and the management contracts. The figure of the development that just came online, you say you have it 35% preleased, but you don't expect it to be tenant -- those tenants don't start coming until early '18, is that right?

[Todd Meredith:]

No, we've got a tenant taking occupancy this month. And then we have another one 16,000 square foot tenant taking occupancy a couple of months after that, and then the balance of that 35% will take occupancy in the first quarter of '18.

[Chad Vanacore:]

Okay, I thought it was 35% in '18, so how long should we think about the lease-up period after that?

[Todd Meredith:]

Yes I mean, I think if we look at it from the standpoint of looking at the pipeline that we have of tenants, we think that, that 50,000 square feet that I described in my comments, that could be realized as early as over the next 12 months. And then you've got to build up a space and expect those tenants to take occupancy over the next 12 months to 24 months. So really this development kind of falls in line with our typical lease expectation within two years after the building COs and we expect that this development will be on that track.

[Chad Vanacore:]

All right. So how should we think about how it's running today? I assume you're taking some kind of operating losses on that right now versus when it's fully occupied.

[Todd Meredith:]

Yes I mean, as it stands today, yes there is the operating expenses that we're incurring. We think that whenever the property reaches that 35% preleasing level occupied that it will be breakeven on operating expenses. And then from there as it moves up to the 85% level, we'll begin to cover and produce the yield on the investment.

[Christopher Douglas:]

Chad one thing to point out is the property COed on 630, so it was in CIP so there was no real impact to NOI in the second quarter numbers.

[Chad Vanacore:]

All right. So how should we think about the impact in third and fourth quarter?

[Todd Meredith:]

Pretty minimal. It'll be small. Not much in the way of operating loss as Rob described the lease-up.

[Chad Vanacore:]

Got you. And then just thinking about the property operating agreement that expires in 3Q, what's the impact there?

[Todd Meredith:]

Actually the property operating agreements expired last third quarter, so they're just creating a comparable difference in our same store numbers. We only have one property operating agreement left and it expires in January of 2019.

[Chad Vanacore:]

And then are there any kind of purchase opportunities we should consider later in ' 17 as well?

[Christopher Douglas:]

Yes, we had talked about it, it's in our supplemental. We do have the properties that we talked about last quarter in Roanoke, Virginia that have a fixed price purchase option that will actually close, most likely close in the first quarter of '18. We've had discussions with the hospital and they do plan to purchase those 7 properties for roughly $45 million, but we've not received official notice yet, but we expect it to be coming soon.

[Operator:]

Our next question will come from Jordan Sadler with KeyBanc Capital Markets. Please go ahead.

[Jordan Sadler:]

I just wanted to follow-up on that repurchase question. Technically -- in [indiscernible] it says there is -- there was $3.1 million of NOI that came from the repurchased properties in the first 6 months. Is that safe to annualize, so $6 million of NOI?

[Todd Meredith:]

Yes.

[Jordan Sadler:]

So curious about the acquisition pipeline. You've maintained your guidance for the full year. I heard the commentary that, it sounds like it's mostly -- it's going to be fourth quarter weighted at this point. Can you maybe talk a little bit about the pipeline and if there's been a delay in transactions relative to expectations or what exactly is going on in the transaction market?

[Robert Hull:]

Yes, this is Rob. I wouldn't say there's been a delay. It's just we've got a number of opportunities in the pipeline, some of them are relationships that we've been working on for a while and just a matter of working through the deals that -- the details of the transaction and getting some of the sellers to move a little quicker than perhaps they would like. Most of the opportunities are kind of $1 billion and $2 billion opportunities. They are in markets that we currently are in, and in a lot of times on campuses where we currently already are. They largely are not marketed properties, so you're dealing with the individual owner. Sometimes there are tax implications that you have to move through. And so we think that with our pipeline and the volume of that pipeline, that we can achieve and hit a guidance range that we put out there.

[Jordan Sadler:]

It was anything that slipped or got a bit away? I noticed there were 785,000 of dead deal costs or deal costs in the quarter, I was curious what those were attributable to.

[Todd Meredith:]

Certainly those [indiscernible] are certainly related to the acquisitions that Rob walked through that we closed. Obviously one of those was subsequent to the quarter, so not that one. But also related to last quarter, looking in the second quarter, looking at the Duke transaction, I think we certainly indicated we took a hard look at that, competed on that and certainly spent some money on that process.

[Jordan Sadler:]

Are you guys capitalizing costs into the overall prices and acquisition now? Have you updated your accounting policy or not yet?

[Todd Meredith:]

Yes, we are.

[Jordan Sadler:]

Okay. So anything you closed, the pursued costs would be in the overall -- wouldn't be running through the P&L. Am I looking -- thinking about that the wrong way?

[Christopher Douglas:]

A portion of it is capitalized, a portion of it is not. But yes, we have started capitalizing part of the new accounting rules.

[Jordan Sadler:]

Last one...

[Robert Hull:]

I'd also -- this is Rob, just on your comment about pace, I think one of the things to point out. If you go back and you look at our history of acquisitions over the past few years, most of our volume has been backloaded in the year. If you look at our investment pace today, it's actually ahead of where we have been on average for the past few years. So again, we remain confident on our guidance range and think that we will -- it will hit by the end of the year.

[Jordan Sadler:]

It's helpful. And then just on the -- I guess also sticking with transactions, Rob, maybe I noticed obviously that you guys -- disposition is done and now you're basically at the low end of the raised range. So are you guys pretty much done on the disposition front? Is there anything else that's kind of strikes your fancy as being less appealing within the core portfolio?

[Robert Hull:]

I'd say for this year, we're largely done with dispositions or maybe one small asset that might close this year. But I'd say what we've -- what you see and what we've closed on this year is largely the bulk of our disposition activity.

[Todd Meredith:]

And I would say, certainly Jordan, that we would expect that we sort of have a run rate every year of $50 million, $75 million of dispositions and that's just an ongoing process of evaluating the portfolio. And as we described in our prepared remarks, that's largely about looking through the portfolio at our growth profile, propensity for growth from these assets. So like the inpatient rehab facilities we sold this year, it's going through and identifying those, as well as MOBs. We sold some MOBs this year that just we think, sort of the best growth is behind them and it's time to move on. So it's a constant process. While we're done for this year largely, I think we will be evaluating what will keep us rolling into next year on that front.

[Operator:]

Our next question will come from Vikram Malhotra of Morgan Stanley.

[Vikram Malhotra:]

Thank you for giving the additional information on CapEx, TIs, et cetera. Looked through sort of the quarterly numbers, just wondering do you have -- if you looked at sort of the trend over the last 2 years or 3 years, are the percentages versus NOI or just $1 per square foot per annum? Are they somewhat similar or is there -- can you give us a sense of what's the range if you look at the last 3 years?

[Christopher Douglas:]

Yes. Vikram, it's Chris. We have tracked that and we do feel like it's generally consistent. As we've talked about before, we say on renewals that $1 to $2, probably more than $1.50 to $2 per lease year, and then on new leases were in the $4 to $5. Now in any particular quarter, that is going to move around with inside that range or maybe even a little above or below that range depending on the particular circumstances. But in terms of long-term trends, those are the numbers that we've shown and what we expect.

[Vikram Malhotra:]

Okay. And then just on the rent spreads, 9% seemed pretty high just versus the last few quarters. Was there anything sort of one time in there and maybe can you give us a sense of -- I know you've ranked the assets over the last few months, say where you've put them into different categories, what were the spreads across those categories?

[Todd Meredith:]

Yes. Vikram, the spreads were pretty consistent across the portfolio. I mean we had 15 different markets where we had spreads of 3% or more. So it wasn't just any 1 particular market. The average was benefited from -- as we've talked about to you before in detail, we just didn't have any negatives this quarter and we did have strong growth in the 4% or more with 62% of the leases being above that 4%. And as I did mention in my prepared remarks, it was impacted by the strong fungibility score properties. We have about a third of our properties score 9 or 10 on the fungibility score, the highest, ratings, where nearly 50% of our renewals this quarter came in those categories. So that certainly did help us. As we are looking out through the remainder of the year, it looks like that the proportion will be more similar to what the average is. So we're not saying 9 is a run rate, it's great when it occurs. But as our guidances is indicated for the year, we think the 3% to 6% is certainly achievable.

[Vikram Malhotra:]

Okay. And then just last one. There seems to be roughly $500 million portfolio out there. Are you looking at that, do you have a sense of kind of where cap rates may shake out? And any sense of just other -- any color on other portfolios out there of size?

[Todd Meredith:]

Vikram. Yes, there is a number of portfolios that are fairly sizable. I think a lot of folks have talked about those -- just rumors out there. We're looking at everything. As we'd always say, I think as Rob said most of what we do is individual properties or smaller portfolios. But we always take a look at the bigger portfolios as well. We learn a lot, we looked and put card on the Duke portfolio as well. So we'll always look at them. Where the pricing shakes out, that's hard to say. I think we all know there's sort of floor with some of the big deals around the Duke transaction and pieces of that around that 4, 7 level. So where it comes, we don't know. You've got to believe it's somewhere north of that, but who knows, if somebody just steps out on those. As far as we understand right now, the process is on. It's are still too early to know where those will shake out, but probably later this year.

[Operator:]

Our next question will come from Michael Knott with Green Street Advisors.

[Michael Knott:]

Hey guys, just wanted to ask you about the 603 comment. It seems like that in terms of the overall industry, thoughts around that, it kind of subsided in recent quarters, I would say. And it seems like you guys were kind of bringing that back up. So I am just curious, was there something specific that sort of triggered that coming back on your radar to a larger extent? Or just any comments on that would be helpful.

[Todd Meredith:]

Well I think, Michael, the thing that triggered the discussion again or most recently was the new proposed rates from CMS on the 2018 fee schedules. And in that, they highlighted this further adjustment to this conversion between the color to relativity adjuster to -- between the outpatient perspective payment system that hospital departments bill under versus the physician fee schedule that they're trying to migrate to for these off-campus hospital outpatient departments. So I think our goal in that, as Bethany described very well, is that we want people to understand it's not a further cut from what they originally planned. It's just step 2 in a process of this conversion that they're going through and looking at the TV schedules and trying to equate them the best they can. So it's -- I think our key is it's not anything new from the original goal, even though it appeared and sounded like in some of the press on it, but it was a further cut.

[Michael Knott:]

And then when you think about just broader risks for the industry, where would you rank that as compared to new supply which seems pretty moderate? What's the broader risks that you see in general to MOBs to the extent that --?

[Todd Meredith:]

Yes, I wouldn't put 603 high up there. As Bethany described, it's fairly small as a portion of our portfolio. Certainly there is some added benefit of those tenants that are grandfathered wanting to stay for a while. I think the risk on that is further out as we described. When those tenants eventually, down the road, come upon their lease expirations, 10 years, 15 years, 20 years from now, they certainly could face some issues in terms of wanting to stay there or losing that grandfathered status and then backfilling, and that would be tough. So not really the current risk. I think the bigger risk we see are just broadly around and we pointed out reimbursement risks in general, flare up a little more out there off-campus and you get different loopholes, different strategies that change more quickly off-campus, whereas on-campus it's more resilient and robust and consistent. So we again see that as a lot much lower risk place to invest.

[Christopher Douglas:]

Okay. When Jordan and I are still young 15 years from now, we will be [indiscernible].

[Todd Meredith:]

As some people say, it's probably a nothing burgers for now.

[Jordan Sadler:]

On tenant retention, obviously 90% is a really good number. Your numbers for the year, first half of the year I think we're 80% and now 90%, but the guidance is still 75% to 90%. So does that imply that there will be lower retention in the back half of the year?

[Christopher Douglas:]

I think that generally it will bounce around on you from quarter-to-quarter, that's the reason we kind of have the range from 75% to 90%. As you pointed out, we were closer to the lower end of the range in first quarter, higher end of the range in the second. But our expectation is what we will maintain in that 75% to 90% through the remainder of the year and into next year.

[Jordan Sadler:]

Okay and then just on the rent bumps, I think you might have mentioned that newer releases at 3.3% bumps. Just curious, is there a growing ability to secure over 3% bumps or how is that progressing?

[Robert Hull:]

Yes, I think it goes a lot to what Todd had talked about in terms of the composition of our portfolio from a fungibility perspective and those higher fungibility properties, as well as our increased investment in some higher growth markets out on the West Coast has allowed us to experience the averages and the instances where we can have bumps exceed the 3%.

[Jordan Sadler:]

Okay and then if I can nitpick you just a little bit. There was a tiny, tiny uptick in bad debt expense this quarter, is there anything there?

[Christopher Douglas:]

No, there's nothing there.

[Operator:]

Our next question will come from John Kim with BMO Capital Markets. Please go ahead.

[John Kim:]

You have a fair amount of leases expiring for the remainder of this year and also heading into the next couple of years. Can you just remind us how much of that has already either been addressed or you feel confident to discussions that they will be renewed?

[Todd Meredith:]

Yes I mean the -- our lease roll is pretty consistent year-over-year. So the percentage that we have this year is similar to what we've had in years past. We have a page in our supplemental that kind of walks through what our -- excuse me in our investor presentation, it walks through our lease maturities and our multitenant properties in what we've seen over the last 6 years, and what we see moving forward. So at Page 27 of the investor presentation. So 15% to 20 % lease roll has been our history and what we expect moving forward and our tenant retention has remained in the that mid-80s, and over that same time period our cash leasing spreads have been going up. So we don't have any real concern about our lease roll.

[John Kim:]

And what are your thoughts about pushing occupancy higher going forward maybe taking on lower rent?

[Todd Meredith:]

Yes well certainly I don't think you would see taking lower rents to do that. I will say our absorption in this quarter was positive, so kind of against the backdrop of strong statistics otherwise like the cash leasing spreads, NOI growth, some of that was helped, as Chris described in his remarks from absorption. The absorption can move around a little bit just depending on units like, like any broad stat like that. There's a lot of movement behind occupancy you have, you have move-outs, you have new leases and they can vary quarter-to-quarter. So that will come and go. I would say we're in the high 80s, we certainly see that trend line-wise over many quarters in the next few years, moving up partly through the absorption, natural absorption but also just through culling the portfolio and the assets we're buying at higher occupancy levels and assets we're selling certainly in the MOB side usually are on the lower end. So it's a process that's multi-year, but the trend line is certainly up moving towards that 90%, 90% plus level.

[John Kim:]

Okay and then on your recent acquisitions, can you just maybe elaborate or provide some color on how competitive it was to buy in markets like LA and San Francisco and where you see the potential upside on those properties?

[Todd Meredith:]

Yes, to your comment about how competitive it is, those 3 assets that we acquired, two of them we have been ongoing dialog with the owners for quite some time, they were not marketed properties, we had relationships with the owners. So it certainly gives you an advantage in terms of acquiring those assets without going through some process. The other was a mark-to-market opportunity and you have to compete for the highest quality assets. So, as we all say when we see something we like we want to get aggressive about it and that we didn't. So can you repeat your other question?

[John Kim:]

So are there long-term leases, is there, what's the mark-to-market opportunities on some of these?

[Todd Meredith:]

All the buildings are multitenant properties. They have -- they're ranging anywhere from 4 leases in one of the buildings to as probably up to 15 leases in one of the other buildings. I wouldn't say that there is, most of the lease rates are within market. So in terms of getting some big mark-to-market opportunity I don't see that in these properties, but they do have good growth potential. In the DC properties, the average bumps are little less than 3% right now and we see an opportunity to take this up. You've got -- in LA average bumps that are around the same level. So we see some opportunities there to come in and apply our leasing philosophy and improve that growth over time.

[Operator:]

Our next question will come from Rich Anderson with Mizuho Securities. Please go ahead.

[Richard Anderson:]

So just quickly, G&A came down at least relative to what our expectation was. Is there any reason why you think you're running at a lower G&A level going forward? Is the second quarter a reasonable run rate?

[Todd Meredith:]

I think second quarter is a reasonable run rate. Second quarter does come down from first quarter as we talked about just because of typical first quarter kind of G&A items. So the drop to us was in line with what we expected.

[Robert Hull:]

Rich you probably saw this, but we certainly also took a step to break out acquisition, proceed costs on the base of the income statement. A lot of folks -- businesses have been doing that and we adopted that as well. Just to clear up any misperception, I should say.

[Todd Meredith:]

We've been doing that historically, but we've been doing it through our normalization, so it's actually people are having to look 2 different places and we had some questions about that and so we decide to go ahead and try to make it more clear to people and go ahead and break it out on the face of the income statement.

[Richard Anderson:]

In terms of the big cash releasing spreads, 9.5%, you identified 2 situations in Nashville and San Antonio where you had a like a 40% pop, but no escalators beyond that. Is that -- should we view that as sort of exceptions to the rule or are you starting to see deals like that where you get this big pop up from, but nothing behind it. Is there a change going on that you see or is it an exception?

[Todd Meredith:]

No, that was just in -- on that one deal in St. Anthony on that 19,000 and that's the only one we have, and so that is certainly the exception not the rule.

[Robert Hull:]

If you look at our portfolio Rich, about 6% of our leases have no increase and -- or actually it's less than that. That's the nonannuals and it's like 3% or 4%. We specifically try to avoid that. So this was one where they pretended, just demanded it. We got comfortable when you do a 5-year lease with a 40% cash leasing spread, you're still averaging about 8% a year. So we thought that was pretty good.

[Todd Meredith:]

To make sure that numbers are not going up.

[Robert Hull:]

Yes no increases turned greater than a year is 2.8%, and the majority of those come through acquisitions we inherit them is very, very rare. It's about the one that will happen this quarter, is about the only one that I can remember in recent history that we've actually signed.

[Richard Anderson:]

Yes. Could you guys or can you break out your same store revenue into 2 components rental revenue and tenant recoveries, or do you do that at some place?

[Todd Meredith:]

We don't, we do not. Obviously we have that detail, but I think the thing we would caution on that and this is not common on anybody else who does that, I know HTA does that. The confusion that can come from that is when you signed leases each quarter and we, I think we've renewed 79 leases in the quarter, when you do that, a lot of times we might be converting the lease structure from gross to net or net to gross or some modified version in between. And that will totally skew the perception of the trend line on those expense recoveries. And I would say we do a fair amount of that, that completes conversion in the structure. So to look at those trends, sometimes we try to look at ourselves and obviously, we get into the weeds on that, but the point is it would be -- we think it's a nonindicative piece of information and it just kind of confuses things, because then you get this wild number, I know HTA had a large growth in their OER this quarter and they may have had some lease conversions that drove some of that. So we don't think it's very helpful, whether or not we put it out there, I think it just depends if other folks find it helpful.

[Richard Anderson:]

So you mean going from gross to net means your kind of recovery number would go up? So you're saying --?

[Robert Hull:]

But your overall net rent, net NOI may not change, but it could show that you're showing a big drop in base rent, but a big increase in recoveries and people and what's driving that. So it can create more noise and as Todd said, it can be difficult to kind of weed through all of that noise to get an indication of where things are really moving.

[Richard Anderson:]

Is it a 20% -- I mean I get in the noise, but if you look over the long term, you should have a reasonable kind of view of it, actually kind of you wade out all that type of noise, can recoverage be 15%, 20% of total same store revenues or does that sound high to you?

[Robert Hull:]

That sounds high. I want to say it's more, it's well 15% is probably reasonable.

[Todd Meredith:]

I think that's enough, that's reasonable.

[Douglas Whitman:]

Hi Richard, this Doug. I think in the 10-K that we filed earlier this year, we do disclose I think that last year tenant recoveries were about $66 million, which -- that would be about 17.5%. So right between the 15% to 20%.

[Richard Anderson:]

Okay good enough. Lastly so there is some debate about how medical office and healthcare in general will fill the void of the kind of the retail disruption going on from eCommerce. So we're touching on many different industries in this question, I guess, but I'm curious where you stand. I know you're on-campus focus, I get that, but do you, if you were to sort of just take a step back and think about the market holistically, do you expect more of that to happen, whether you like it as an investment or not, I mean, what is your view about medical office becoming a part of the retail conversation longer term?

[Todd Meredith:]

Well, we certainly wouldn't disagree that, that's been going on.

[Richard Anderson:]

It's been going on, but is it going to continue to go on, I guess?

[Todd Meredith:]

Yes and I'd say we don't disagree with the trend that a lot of health systems are doing that. And they see that as part of the strategy and they call it various things over the years. This was happening in the '90s, probably in the '80s and it's just gotten to be a little bit of hotter topic more recently again. And it's really just this concept of getting these health systems, putting in positions, putting their brand out there, putting a location out there, capturing patients and then obviously getting utilization. And then when they need to sending them to the hospital, sort of the hub-and-spoke model. So that's very much alive, I don't see that changing. I think our view is, there's nothing wrong with that, there's a lot of need for outpatient services that will barely and really probably fall short of the demand. So that is necessary but our view is that's not necessarily leading to a good real estate investment and risk profile. So our view and we don't think it's to the detriment. I guess I would say to be on-campus site. There's plenty of growth and demand for on-campus growth and outpatient needs as well. It's just an extension of what they've been doing for a long time and it kind of shape shifts over time. You are seeing -- and I think we've been talking about for years, these large outpatient centers off campus, and we have a couple of those. So we're not denying that trend at all. We just think the safety of the real estate investment risk profile is the key.

[Douglas Whitman:]

Hey Rich, this Doug. [indiscernible] a lot of the care that you see delivered in some of these more retail locations is more sort of maybe primary care focused, more consultation type visits between patient and provider, whereas our on-campus settings, you see more procedural base care, higher acuity care delivered and that's why our portfolio SKU is much higher towards specialist. And I think you'll see more of those procedural care setting still being close to the hospital. And so the more retail -- and I think that's probably looking at the same pool of spaces, maybe off-campus properties. And so I think off-campus landlords may be more -- will be more concerned about the retail side. But I think on our on-campus settings, I don't really see them sort of fishing for the same pool of tenants.

[Operator:]

Our next question will come from Tayo Okusanya with Jefferies. Please go ahead.

[Omotayo Okusanya:]

Yes good morning. In regards to acquisitions being more of 4Q weighted, could you talk a little bit about if any of that's also being driven just by the market basically readjusting to lower cap rates and now there is kind of more back and forth negotiations between buyers and sellers and that's kind of what's causing part of that to be more back weighted now?

[Todd Meredith:]

No, we're not seeing that, that hasn't -- I think everybody who's a seller and the brokers that get involved in these things are certainly aware of the low cap rates that have happened on some bigger transactions, but we're not seeing some big re-trade going on in our processes.

[Omotayo Okusanya:]

Okay. And then just in regards to where again development yield is being so much higher than acquisition cap rates today, could you talk a little bit about just how big your development pipeline could get versus where it is today.

[Robert Hull:]

Well I think if you -- what we've said is that we look to have about $50 million to $100 million in starts every year. If you look at our pipeline, we think that there's probably a few years' worth of opportunity that will meet those levels. So we feel confident that over the next few years we'll be able to deploy that $50 million to $100 million.

[Omotayo Okusanya:]

Okay. So you use a -- kind of making that assumption in regards to additional development starts, for modeling purposes, you guys will be comfortable with that?

[Todd Meredith:]

Yes, that $50 million to $100 million per year range that Rob described, I think is certainly something that's visible based on the pipeline.

[Operator:]

Our next question will come from Michael Mueller with JPMorgan. Please go ahead.

[Michael Mueller:]

Hi, I got two quick ones here. First of all, on the first quarter purchase option sale of the $45 million, that cap rate that's the high cap rate or is that going to be in the low teens, is that correct?

[Todd Meredith:]

Yes that's correct. So if you take the $3.1 million for the first half and annualize that across the approximately $45 million, you're right, it's in the low teens.

[Michael Mueller:]

Got it, okay. And then I just want to make sure I'm understanding on the development side to get up to that 1 to 150, it looks like it's based on the stock rate now. The next set of buildings that comes online, we're going about 2019, so near term, we're probably going to see the spend continue to ramp up to that called 100, 150 level. And then from 2019 going forward, from a modeling standpoint, that's when we should start to pick up kind of more recurring consistent projects coming online in that. Is that the right way to think of it?

[Todd Meredith:]

I'm not sure I follow the 100 and 150 you mentioned.

[Michael Mueller:]

$50 million to $100 million, sorry.

[Robert Hull:]

Yes $50 million to $100 million in terms of a development starts every year. So if you look at what we're starting this year, we've got the $64 million project out in Seattle, that will be starting at the end of this year and then we've got the redevelopment that we started this quarter, $12 million. So it puts you for this year in the $76 million range in terms of development starts.

[Todd Meredith:]

Yes I think the key thing there is Rob's talking about starts and I think you're looking at spend and I think you are right, that the spend could lag a little. But what Rob's really getting at is sort of starts in production from the pipeline. So you're right, it certainly can have inflow a little bit based on the timing of those starts.

[Operator:]

Our next question will come from Todd Stender with Wells Fargo. Please go ahead.

[Todd Stender:]

Hi, just some follow-ups on the new acquisitions you made. So probably for Rob, you're quoted cap rates are in the 5.3%, 5.4% range. Can you -- and those are projected, can you go through what you underwrote on a trailing 12-month basis and then how much CapEx should we expect to be budgeted for each?

[Robert Hull:]

Those yields and we're going to assume some CapEx that we underwrote into the acquisitions. I don't have the exact number off the top of my head, but on the trailing -- the yields on those are based on in-place leases that we underwrote. So there's not any lease-up in their assumed lease-ups. So think if you were to look at the trailing 12 months, it would be how indicative of those yields that are --

[Christopher Douglas:]

I mean you wouldn't have, you maybe have a bump and some escalators. But we've added the capital that we're going to spend. So, it's probably similar in terms of yield.

[Robert Hull:]

That's right.

[Christopher Douglas:]

Yes that's something I think -- you're on to something Todd, in terms of cap rates and disclosure on that can be a little all over the place. But we tried to take a conservative view, as we just described and we don't assume lease-up in an asset in the first year yield that we disclosed.

[Todd Stender:]

So if you're quoting a 5.3% for example, it's pretty darn close to maybe what the trailing is, because you're not taking a CapEx assumption and then applying like any yield which skews the cap rate higher on a initial projection.

[Christopher Douglas:]

Yes correct.

[Todd Stender:]

Just asking if you went through this, who the sellers were, were they the hospitals system selling or they were all private sellers?

[Todd Meredith:]

No they were, two of them were private sellers, and one of them was a hospital system.

[Todd Stender:]

Did they require any tax efficient funds, did you issue any OP units, anything like that?

[Todd Meredith:]

No.

[Todd Stender:]

Okay and then finally, just the remaining lease terms for some of the large tenants in there, when are these supposed to roll in and how long are they in place for?

[Todd Meredith:]

The larger tenants -- they are, they range in that 5-year to 10-year window. They vary -- one of the buildings is quite diverse in terms of its tenancy. And I don't have the weighted average lease term off top of my head, but we can certainly get that.

[Robert Hull:]

We can get that for you, but I would expect it's pretty similar to our portfolio. It was not a bunch of in-place long-term leases. These are multitenant properties with leases -- kind of continual lease roll, as we see inside of our existing portfolio.

[Operator:]

Our next question is a follow-up from Michael Knott with Green Street Advisors. Please go ahead.

[Michael Knott:]

Hi just a couple quick ones. I guess, to ask directly, 2 of your main peers, I guess have both sort of taken their turns out in the market, tell them to go stand with their nose in the corner for buying sub-5%. Is that anything that you guys would do or is that [indiscernible]. How do you think about where the breakpoint is on a yield basis?

[Todd Meredith:]

I certainly think that for us, it comes down to the portfolio in evaluating the situation relative to our criteria, but really as we describe, it's really about the internal growth. So if we saw something that had, it's going back to those cap rate disclosures we were talking about with Todd earlier. If we see an ability to move that quickly, so year 1, year 2, you can move beyond that. It's not out of the realm of reason, but I think it's got to be accretive and so I think that kind of holds that bar pretty high. Certainly on the Duke transaction we couldn't get to the levels that were paid. So I think that should be a good indication of sort of a stopping point, it's probably around that 5% mark, but you start to push the envelope. But it's all about the growth potential. If the growth is there and you can see a quick path to accelerate growth and improve that yield and have long-term growth potential and safety, then it's all about each situation in that respect.

[Michael Knott:]

Right. And then just from a replacement costs or price per pound basis, it looked like the deals you did this quarter in the stock markets were around 350,000 to 400,000 per foot. Just curious if replacement cost is something that you think quite a lot about and are these deals in that range, sort of near replacement costs or is there still a little bit of room or how are you thinking about it?

[Todd Meredith:]

It varies. We certainly focus on it. As a developer, we're very aware of what development costs are, situations just kind of vary by market size. As Rob described those markets are fairly high cost markets. So I do think those are probably fairly safe on that issue. The other side, I'd say is there can be unique situations in an on-campus setting where you may be buying a garage or not buying a garage, paying for land or not paying for land because there is ground lease. So some of those numbers can be a little skewed and need to be adjusted if you're thinking about true full replacement costs for a competitive building. And there just may not be any competitive plots or land around. So we do think about it, but it's all about again as we described that fungibility scores, looking at the whole picture of competition as well as replacement costs.

[Christopher Douglas:]

I think the asset in DC is a good example. I mean it's a landlocked campus, whereas Rob mentioned in his prepared remarks we're integrated with the hospital. You can't really tell where our building ends and the hospital begins. And there are no other parcels around. So you would have to tear something down, so that would certainly increase the replacement costs. You can't just look at what is construction costs, you've got to look at it on a case-by-case basis.

[Robert Hull:]

In Seattle, we're seeing a lot of that. We're building this, one on the UW campus. Seattle campus that's -- we will probably -- it's less than $500 a foot.

[Christopher Douglas:]

We're less than -- we're about $450 there but the hospital is constructing a garage, that's going to serve the entire campus as well as this building.

[Robert Hull:]

We think a competitor would have to come in and spend $600 or $700 a foot to really build something competitive nearby.

[Operator:]

Having no further questions, this will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Todd Meredith for any closing remarks.

[Todd Meredith:]

Thank you to everyone for listening this morning. We'll be available, we know it's a busy earnings season, but will be around for any additional questions. And we hope everybody has a great day. Thank you.

[Operator:]

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