Healthcare Realty Trust Incorporated
Q3 2014 Earnings Call Transcript

Published: 5 Nov 2014

[Operator:]

Good morning, and welcome to the Healthcare Realty Trust's Third Quarter 2014 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mr. David Emery. Please go ahead.

[David R. Emery:]

Thank you, and good morning, everyone. Joining us on the call today is Scott Holmes, Doug Whitman, Todd Meredith, Carla Baca and Bethany Mancini. Now Ms. Baca will read the disclaimer.

[Carla Baca:]

Thank you. 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 the Form 10-K filed with the SEC for the year ended December 31, 2013. 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 or FFO per share. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release for the third quarter ended September 30, 2014. The company's earnings press release, supplemental information, Forms 10-Q and 10-K are available on the company's website.

[David R. Emery:]

Thank you. We're pleased with the progress this quarter, positive operating metrics and active leasing produced solid internal growth. The company's tenant retention, cash re-leasing spreads and annual red bumps again reflected healthy momentum in the portfolio. Being aligned with well-established health systems and having superior risk coverages and low fungibility, we foresee meaningful and sustainable internal growth enabling the company to be selective in prospective acquisitions, reducing risk and enhancing returns. We're seeing health systems beginning to surface from the implementation of the Affordable Care Act as they look to rationalize their assets and strategically position themselves for the future of outcome-based lower-cost care. Accordingly, discussions with health systems for new outpatient facilities are now more active than we've seen in some time. With improving profit margins, health systems are dusting off plans for new outpatient facilities and looking to partner with Healthcare Realty as they examine their investments in light of ongoing capital demands. Given the size and growth of the outpatient property market, we anticipate our development projects will be selective and proceed at a measured pace. For us, mostly on campus with significant leasing from hospital-driven services. As we begin our third decade, Healthcare Realty's long-held investment strategy remains focused and relevant to the current trends and changes in the health care industry, keeping the company's cash flow predictable and providing the foundation for growth in the years to come. Now I would like to pass it on to Ms. Mancini to summarize our views on current events and trends as we do every quarter. Bethany?

[Bethany Mancini:]

Healthcare providers are reporting positive trends in patient volume and earnings for the third quarter with an optimistic outlook for higher revenues from exchange enrollment and Medicaid expansion this year. Coupled with favorable economic conditions and faster rates of health spending growth, hospital companies anticipate improved profit margin as they move beyond the costly initial phase of implementing reform-based initiatives. Even as the nuances of health insurance reform continue to unfold, it is becoming evident that the leading health systems will be those that can attract greater patient volume, expand market reach through specialization, adopt payment models that follow ACA incentives and improve quality outcome. The role of outpatient care, particularly in nonhospital setting, is becoming increasingly valuable in this environment and an even greater priority for health systems. With slower growth in Medicare payment rates for providers, higher cost-sharing requirements for patients and the expanding role of physicians to meet increased volume demands at lower costs. We view Healthcare Realty's medical office facilities as well-positioned to thrive in the movement towards more efficient outpatient settings. Employment data continued to support this trend. Last month, ambulatory care jobs increased 3.1% over the previous 12 months, physician office increased 2.5% and outpatient care centers increased 4.8%, while hospital hiring improved only 0.5% over the past year. Healthcare Realty's focus on outpatient facilities over the past 20-plus years have proven a profitable defensive sector for investments, surviving numerous economic cycles and Medicare DRG and prospective pay overhaul. And now the company stands to benefit from the aggressive shift to increase ambulatory services in both urban and suburban markets. In the end, when this round of health insurance and reimbursement overhaul settles, we expect the differences in health care delivery to be arguably not all that different. Medicare rates for physicians are set to remain stable through the end of March 2015 when Congress will need to again pass legislation to prevent a payment cut, most probable being another short-term fix. Republicans picked up 7 Senate seats last night in the midterm elections so far to gain control of Congress. Without the votes to override a presidential veto, meaningful change to what has already been fully implemented for health insurance reform remains unlikely. Although congressional votes to repeal the Affordable Care Act will certainly be forthcoming, followed by piecemeal legislation to repeal its unpopular measures, which have a higher probability of passing prior to the next presidential election. David?

[David R. Emery:]

Thank you, Bethany. Now, on to Mr. Meredith to give us more specific information regarding recent investments and development activities. Todd?

[Todd J. Meredith:]

Over the past 12 months, aggressive pricing and limited supply of suitable assets in the medical office sector have shaped Healthcare Realty's expectations for modest net investment activity. And throughout 2014, pricing has continued to compress. The company's outlook for acquisition cap rate has shifted lower by 25 basis points for the second consecutive quarter to a range of 6% to 7%. Healthcare Realty is not inclined to chase cap rates and will continue to pursue only assets that offer the best risk-adjusted value at price levels that exceed the company's implied cap rates. In just the last few weeks, we've been pleased to see another scope of increase in a number of assets that fit our criteria

[David R. Emery:]

Thanks, Todd. And now, on to Mr. Whitman to give us an update on matters of capital markets and financials metrics.

[B. Douglas Whitman:]

Recognizing the current cap rate environment for MOBs where we have seen continued compression, most notably among the lower quality assets, we continue to view dispositions as an important source of capital. While this recycling of capital into assets with better long-term growth prospects factors into our capital planning, the nature of these transactions is less predictable than other sources of capital. Accordingly, during the third quarter, Healthcare Realty raised a modest $23.6 million of equity through its at-the-market, or ATM, program. After the quarter ended, the company raised an additional $1.5 million. Year-to-date, we have raised $53.3 million at an average price of $25.06 per share. We have raised this moderate amount of equity at prices above our implied cap rate to accretively match fund our acquisitions. We continued to see improvement in several of our key debt metrics with overall leverage down slightly to 42.4%, fixed charge up to 2.8x and debt-to-EBITDA down to 6.5x. Over the past several weeks, there has been increased volatility at the public debt market, with yields moving up in mid-September, dropping sharply in mid-October and settling in the 2.25% range now. It appears that interest rates will remain fairly low for the foreseeable future, which is beneficial for funding new investments and refinancing the existing debt. However, we recognize that when interest rates move, they tend to do so quickly. So we will continue to monitor the debt market carefully. We have always had the view the tenant leases should be less bond-like with shorter terms to provide flexibility and insulate the company from interest rate spikes. Furthermore, HR's growth is primarily derived from steady increases in lease rates within our portfolio and is not predicated on an outsized amount of acquisitions, which become increasingly difficult in a rising interest rate environment where capital costs and sellers' expectations of cap rates are in disequilibrium. We'll see many of you in Atlanta in a few hours.

[David R. Emery:]

Thank you, Doug. Now, on to Scott to review operating results and other financial matters. Scott?

[Scott W. Holmes:]

The company reported third quarter normalized FFO per diluted share of $0.37. NAREIT defined FFO per share was also $0.37. The company's normalizing items include an add-back for acquisition costs of $0.2 million and a reduction for a $0.4 million reversal of restricted stock amortization upon the departure of an officer. For the third quarter, the dividend payout percentage on normalized FFO is 81.1%. Normalized FFO dollars year-over-year grew $5.4 million or 17.6% to $35.9 million. Over the same time period, normalized FFO per share increased 15.6%. Sequentially, normalized FFO dollars increased by $1.7 million or 5%, attributable primarily to second and third quarter net acquisitions of $0.7 million, a decrease in property tax expense of $1.1 million, offset by an increase in utilities expense of the same amount, increased occupancy at development conversion properties of $0.4 million and about $0.6 million from the remainder of our operations. The company again produced solid leasing results in the same-store multi-tenant portfolio. The third quarter cash re-leasing spread was 1.4%. Annual rent bumps were steady at 3%, tenant retention was 85.9% this quarter and the spread on re-leasing yields was again positive in the third quarter. With strong tenant retention and leasing activity, occupancy in the total same-store portfolio ticked up slightly to 90.6%. Year-over-year, multi-tenant same-store revenue was up 2.2% and expenses were down 0.1%, which caused NOI to be up 4.1%. A significant contributor to near flat expense growth is a 3% year-over-year savings in property taxes and utilities. Sequentially, multi-tenant same-store revenue was up 0.7%, while expenses were up 1.4%, resulting in an increased in NOI of 0.1%. Our single tenant properties saw a year-over-year revenue increased 1.2% and NOI increased 2.2%. Sequentially, NOI from single tenant properties was up 1.5%. On a combined basis, the total same-store NOI was up 3.6% year-over-year and 0.5% sequentially. As we have said, quarter-to-quarter changes are somewhat seasonal in nature and not necessarily indicative of a trend, and we continue to expect the longer-term same-store NOI growth profile to remain in the 2% to 4% range. David?

[David R. Emery:]

Thank you, Scott. Now, operator, we are ready to begin the question-and-answer period.

[Operator:]

[Operator Instructions] The first question comes from Karin Ford with KeyBanc Capital Markets.

[Jeff Gaston:]

This is Jeff Gaston with Karin Ford here. First question -- I think you might have addressed it in your opening remarks. Looks like SIP NOI recorded a decline of about $100,000, is that entirely due to seasonal utilities expense?

[David R. Emery:]

That's right. We had a little bit of a revenue increase as I mentioned, but it was offset by those seasonal utilities. And again, we had a significant occupancy increase, but there's some rent concessions that will burn off over the next 2 quarters. So that certainly will come into play if that burns off. And that if you look at the run rate, it's more indicative of the NOI that can be generated at this occupancy level.

[Jeff Gaston:]

Right. Okay. And then second question. Given the -- sorry, can you give us some color on what drove the occupancy decline and the portfolio of recent acquisitions?

[Todd J. Meredith:]

Yes, there's 2 things. Number one, we had 1 property that rolled into the same-store portfolio after being down owned for 5 quarters and that accounts for part of that. The other part are some vacancies that were known and underwritten when we acquired the properties. So obviously, we underwrote those and factor those into the initial stabilized deals that we were acquiring at. So those are spaces generally that are being vacated by nonhospital tenants and given the locations, we expect most of that to be backfilled by the adjacent hospital.

[Operator:]

The next question comes from Daniel Bernstein with Stifel.

[Daniel M. Bernstein:]

I guess, I was looking at the 10-Q last night and, I guess, the acquisition that you had, I guess, subsequent to the end of the quarter, looks like you're take on mortgage was about a 6% rate. Is there an opportunity to refinance some of that debt? And then maybe as a follow-up, I was just trying to check and see what you think your cost of debt is on mortgages and unsecured. And may be a follow-up after that.

[Todd J. Meredith:]

Well, in that particular case, the maturity on that note is a little ways out -- I can't remember the exact date, but it's not in the near immediate term. It also has yield maintenance associated with that. So we'll keep that mortgage in place for a while. But broadly, I think our mortgage portfolio...

[B. Douglas Whitman:]

The mortgage portfolio as a whole is about 5.4% blended interest rate, so -- and a lot of the interest -- mortgages that we assume, we have these acquisitions, have prepay penalties or make-whole penalties. So it's often cost prohibitive to prepay early, but generally their maturity is in the next 2 or 3 years kind of retirement.

[Daniel M. Bernstein:]

But what's the cost -- if you were to go out and put mortgages on a property today, what would be the cost out there? Maybe who's providing that? And just in general, have you seen covenants kind of ease up or not?

[Todd J. Meredith:]

Yes, I mean, Dan, we don't do a lot of secured debt. Indications are probably be 4%, maybe a little bit higher, banks, life insurance companies probably would be the likely ones. But again, we don't do a lot of that activity.

[Daniel M. Bernstein:]

Okay. I guess what I was trying to -- if cap rates were coming down 25 bps again, has the cost of capital come down in a commensurate kind of way?

[Todd J. Meredith:]

I think certainly, the cost of capital that we look at, which is more of our equity primarily, but also unsecured notes and so forth. I think you would say it has, whether it's dollar for dollar or percentage for percentage. So it's a little hard to say. But I think, certainly, recently that has happened. I think the debt markets maybe a little less so. As Doug said, they've been a little bit more volatile -- with the 10-year treasury being more volatile. So but I think on average, if you look over the last 12 months, probably so.

[Daniel M. Bernstein:]

Okay, all right. And what's -- so you think it's just interest rates and capital cost driving cap rates down? Or is there some marked increase in interest in the space from nonplayers that -- I think people who have not been playing in the space a couple of years ago, just trying to think about the factors beyond interest rates that are moving cap rates in this space?

[Todd J. Meredith:]

It seems pretty heavily linked to interest rates for now. We haven't seen a tremendous change in the players that are competing for the acquisitions and so forth. So it's the usual suspects and obviously larger transactions where you're seeing more of that compression. Still some certainly on the individual side, but not as much.

[Daniel M. Bernstein:]

Okay. And then the property that's being, I guess it was a purchase option at your sites among your properties. I think I read in the 10-Q. Is that a single tenant property, multi-tenant property and maybe if you -- just talk about whether there's any loss of income there that we should be modeling in?

[Scott W. Holmes:]

It's a single tenant property. The hospital occupies and utilizes or purchases the whole building since we'll be getting a market price for the property, we'll just be able to rid -- to market cap rate, we'll be able to redeploy that asset -- that those proceeds into new assets that's been long cap rates, so...

[Daniel M. Bernstein:]

Right. Just -- maybe a temporary -- yes, just temporary drag until you reinvest at a market. I think that's it for me.

[Scott W. Holmes:]

That closing is not immediate, so it'll stay in asset held for sale until it happens, so it may not even be '15.

[David R. Emery:]

2015.

[Operator:]

[Operator Instructions] This concludes our question-and-answer session. I would like now to turn the conference back over to Mr. David Emery for any closing remarks.

[David R. Emery:]

Okay. Thanks, everyone, for attending this morning. We know a lot of folks are at NAREIT this morning and we're leaving Nashville here in a few minutes headed that way, so we know why there's not many questions because we go to see most of everybody today, tomorrow and Friday. So thank you for being on the call, and we will see you December late next quarter. I guess it will be in February. Thank you. Good day.

[Operator:]

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