Healthcare Realty Trust Incorporated (HR) Q2 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Healthcare Realty Trust Quarterly Analyst Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to David Emery, Chairman and CEO. Please go ahead.

Thank you. Good morning, everyone. Joining us on the call today are Scott Holmes, Doug Whitman, Todd Meredith, and Carla Baca, and Bethany Mancini. Ms. Baca will now read the disclaimer. Carla?

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, 2012. 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, funds available for distribution, FAD or FAD 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 second quarter ended June 30, 2012. The company's earnings press release, supplemental information, Forms 10-Q and Forms 10-K are available on the company's website. David?

Thank you. After a solid second quarter, focus on the company's strategy, strong operating performance and measured acquisition pace, we are pleased with the marked improvement in accreting investment opportunities and the positive outlook for growth in the second half of this year. The company recently completed a $79.2 million equity offering to fund the acquisition of 5 multi-tenant medical office buildings, totaling approximately $156 million. These investments will be accreted to FFO, and we expect them to close in the third quarter of this year, prompting us to slightly increase our range of acquisitions for the year. We remain pleased with the company's capital markets activities since the beginning of the year, eliminating significant capital needs in the second half of this year, extended maturities and locked in lower interest rates for many years to come. Healthcare Realty's solid financial performance and improved credit metrics will enable the company to take advantage of investment opportunities. We expect that refinancing concerns on the horizon, as well as attractive pricing of recent MOB portfolio transactions will prompt sellers to bring to market more properties that meet our quality and pricing objectives. We anticipate measured acquisition activity in the balance of 2013 and into 2014, and we will continue to evaluate worthy opportunities for new development. The nature of the current demand that we are seeing for new facilities is largely hospital-driven, with considerable leasing by hospital affiliates at hand. Healthcare reform and the onset of accountability care organizations, or ACOs, are incentivizing health systems to partner with physicians to decrease admissions and ER visits and to offer more services in lower-cost physician office settings. In fact, physicians are leading the majority of ACOs and reporting better outpatient outcomes and higher pay for quality, which will become increasingly valuable to health systems in the post-reform reimbursement environment. We expect consolidation in the health care industry will require capital and new facilities and cost-effective centralized locations, and should benefit the lease-up of our stabilizing properties. We remain focused on new investments that will prosper in this environment. Looking ahead, we see the future is increasingly bright for the company's prospects, given the size of the industry and reforms that support moving demand for outpatient facilities and tenants. We believe our investment strategy will continue to produce solid near-term operating results, decrease leverage and foster strong, long-term growth. Now I'd like to pass along to -- our next presenter will be Ms. Mancini, who will summarize the views on current events and trends related to the health care industry. Bethany?

Thank you, David. The implementation of health reform and the formation of ACOs remain at the forefront of health provider's initiatives and strategic planning for 2013. The expansion of Medicaid enrollment and the onset of the insurance exchanges next year are expected to lower bad debt for hospitals and increase patient utilization and operating margins, a positive for Healthcare Realty's tenants and the prospect of new investment opportunities in outpatient and medical office real estate. The recent decision by the Obama administration to delay for 1 year the employer health insurance mandate should not, on the surface, have an impact on health providers. Although, patients' insurance could now be become funded more by the taxpayer-subsidized exchanges rather than by employer-funded private plan. And without data requirements for employers or individuals to prove insurance coverage, healthy individuals may decide to forgo insurance, causing premiums to rise and driving more patients to government program. Regardless of changes in the insurance landscape, however, we expect Healthcare Realty's tenants to continue to benefit from the rise in health care demand. Our properties are comprised of a diverse mix of primary care physicians, hospital outpatient operations and physician offices from over 30 specialties. Each practice varying in Medicare and Medicaid case mix, with the average physician office receiving only 30% of revenues from these programs. Furthermore, the expanding bureaucracy that will come with health reform in addition to the sector of lower Medicare profit margin should foster hospital and physician consolidations, which in turn should enhance tenant's credit profiles and market share and strategic investment opportunity. We have seen among Healthcare Realty's tenants this year heightened concern with meeting deadlines for participation in Medicare ACO programs. Indeed, the burden of extracting cost savings from the health care system in order to fund the continued increase in government health program lies heavily on hospitals and health care providers, which makes quality-enhancing measures, such as ACOs, critically important. And, of course, the ultimate outcome of these reforms still remains to be seen. However, even as uncertainty still lingers around reform, Healthcare Realty's leasing progress remains on target for 2013. Health systems and physicians are moving forward to position themselves to the best strategic advantage possible, motivated by positive headwinds of more patient demand, but tampered by the uncertainty of insurance exchanges and quality base reimbursement, which we anticipate will clear as these initiatives unfold over the next few years. Regarding the potential for future reimbursement rate changes, rating agencies continue to stress that providers with investment-grade credit rating have proven their ability over the years to lower cost and find new revenue streams. Such health systems are less dependent on government reimbursement and have larger reserves to withstand any hit to operating margins. Healthcare Realty's diligent focus on investing with quality health systems throughout our 20 years has resulted in consistent growth in rental rate and solid rent coverages in our core portfolio. With nearly 60% of our $3 billion in properties aligned with investment-grade rated health systems, the company benefits from a higher certainty of renewal, market stability and long-term value. Amidst the health insurance changes on the horizon, we continue to believe the driving forces, both in the public sector and the private sector are advancing the population's access to care, emphasizing lower-cost outpatient care and supporting physicians who provide that care. Healthcare Realty is solidly positioned to benefit from the rising tide of health care demand and new reforms that reward efficient care for the entire continuum of the patients' needs, making outpatient service delivery an integral and profitable part of the hospitals' clinical mission and revenue growth. David?

This is Doug Whitman. I'll now address some of the capital markets activities that we've done during the quarter. Over the past few months, the company has completed several capital markets transactions that provide funding for our investment activity, lower our future cost of capital, enhance the company's debt and credit metrics, improve our debt maturity schedule and provide sufficient dry powder for future investment opportunities. As the capital markets continue to exhibit increased volatility in reaction to the specter of the fed's monetary policy changes, the company will continue to remain flexible on how it sources new capital, balancing our capital needs, not only with interest of existing shareholders and creditors, but also with the relative cost of debt and equity given current investor sentiment. During the first quarter, the company extended the maturity on its revolving credit facility until April 2017, and issued $250 million of unsecured senior notes due in June 2023 at an effective rate of 3.85%. Early in the second quarter, in conjunction with that bond offering, the company redeemed its 5 1/8% 2014 senior notes for $277.3 million, paid with the net proceeds from the 2023 notes and availability under its revolving credit facility. As a result, the company's nearest maturity on its long-term debt is 2017, with over 2/3 of the company's long-term debt now maturing in 2021 and 2023. At the end of the second quarter, for $94 million, the company prepaid a mortgage that was secured by several Charlotte properties. We prepaid this mortgage, which had an interest rate of 7.25%, to eliminate an upcoming debt maturity and improve our overall credit metrics. To address acquisitions, the company used its aftermarket equity program during the second quarter and completed a modest equity offering in mid-July in order to prefund these commitments with long-term capital. Year-to-date, we have raised equity at a blended price of $27.31 per share, making these acquisitions solidly accretive. The refinancing of our senior notes at an effective rate of 3.85%, the repayment of that 7 1/4% mortgage and the issuance of equity to fund accretive investments will, in combination with incremental NOI being generated from both our SIP properties and acquisitions, improve several key credit metrics, including our overall leverage ratio, debt-to-EBITDA and fixed charge coverage. We believe that these improved metrics position us to access lower-cost capital to fund the company's future growth. With the capital markets activity we've completed this year, reinvesting the proceeds from expected property dispositions and maintaining a modest balance on our revolving credit facility, we do not expect any significant near-term capital need. David?

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

Thank you, David. The company continues to execute its investment objectives for 2013. We currently have 4 medical office buildings under contract and a fifth under letter of intent. Total consideration for the 5 properties is approximately $156 million. These properties total 528,000 square feet are 95% leased and are located on or adjacent to hospital campuses in several markets where the company has a presence, including in Colorado, Indiana, North Carolina and Washington State. Three of the 5 properties are associated with existing relationships. The company will assume 3 mortgages, totaling $39.7 million and all 5 properties are scheduled to close in separate transactions in the third quarter. At initial cap rates ranging from 6.5% to 7%, these properties will be accretive and the company has prefunded them with equity already raised. These 5 MOBs will bring the company's year-to-date acquisitions to $188.5 million, including the 2 facilities already acquired this year for $32.5 million. Looking ahead for the balance of the year, we are tightening and modestly increasing our 2013 acquisition guidance to $200 million to $225 million from our previous guidance of $100 million to $200 million. Most importantly, these acquisitions reflect our strategy to continually increase the quality of our portfolio with properties that are well located and associated with leading health systems, attributes that generate consistent demand for space and a higher propensity for rent growth. We continue to see plenty of opportunity to acquire individual properties, ranging from $20 million to $50 million at attractive cap rates of about 7% on average. Many transactions being finalized now are largely the result of financially oriented sellers chasing attractive cap rate pools established in late 2012. We're beginning to see some sellers react to volatility and capital markets, moving forward with transactions that were not a priority before the fed chairman's comments sparked sharp changes in the market. Health systems, however, are less responsive to changes in capital markets and we do not expect a spate of hospital assets on the market. Accordingly, demand for medical office building continues to outweigh their available inventory. And in the near term, we do not expect to see significant changes in cap rates given that seller's expectations are slow to change, especially for high-quality strategic assets. During the second quarter, the company sold 5 properties, totaling 158,000 square feet for $12 million and generating net proceeds of $11.1 million. In July, 2 inpatient rehab facilities were sold to HealthSouth for $29.4 million as expected. While HealthSouth has expressed possible interest in renewing 2 additional leases that expire in September, the company anticipates that HealthSouth will purchase the facilities for $35.2 million. The company is increasing its 2013 disposition guidance to $80 million to $100 million, which includes the likely sale of all 4 HealthSouth facilities. Combining the midpoint of our acquisition and disposition guidance, expected net investment activity for 2013 is increasing modestly to $120 million from $90 million based on our previous outlook. Turning to development activity, the company funded $21.6 million towards the 2 build-to-suit facilities that are 100% leased to Mercy Health. Unfortunately, the outpatient facility in Edmond, Oklahoma, sustained damage from a tornado in late May and completion will likely be delayed until the -- later in the first half of 2014. Builder's risk insurance is in place to cover the cost of repairs and Mercy expects to open the facility as soon as possible. The mortgage structure will remain in place through completion and the delay will not have a material impact on our results. The Springfield orthopedic facility, on the other hand, is now expected to be completed slightly ahead of schedule in September rather than November. As a reminder, when the facilities convert from construction mortgages to ownership, the construction period interest of 6.75% increases to a yield of approximately 8%. At the 12 properties in stabilization, which are now 69% leased, leasing momentum remains on pace. Occupancy increased to 48% as we funded $10 million towards tenant improvement allowances. Had all occupants at June 30 taken occupancy and paid rent for the entire quarter, NOI would have been approximately $1.7 million. Reported NOI was sequentially flat at $1.2 million since much of the occupancy gain in the quarter took effect at the end of June and in the normal course, property taxes -- and increases in property taxes were phased in with occupancy gains. With healthy leasing and tenant buildout underway, our outlook for the balance of the year remains positive and unchanged. By year end, we expect these properties to be 75% to 85% leased, 65% to 70% occupied and generating quarterly NOI of approximately $3 million. The 12 properties will soon shift out of the stabilizing portfolio and are expected to generate NOI of $25 million to $30 million when fully stabilized. Looking ahead, we are seeing health systems planning more outpatient services to meet demand in markets where the supply of medical office space is tight. Typically, these health systems are aligning various providers with hospital outpatient services that collectively occupy 50% or more of the new facility. We anticipate at least 1 smaller development start fitting this profile towards the end of 2013, and our ongoing dialogue with providers and developers indicates that we should see some starts in 2014. As we execute our 2013 investment objectives, our investment outlook remains positive. We remain focused on delivering value from our development properties, improving the profile of our portfolio by investing selectively in accretive acquisitions and developments, disposing of nonstrategic assets and managing our long-term cost of capital to deliver increasing net asset value. David?

Thank you, Todd. Now on to Mr. Holmes to give you an overview of the results of operations and other financial matters. Scott?

Good morning. The second quarter produced normalized FFO per diluted share of $0.32, a normalized FAD per diluted share of $0.33. The dividend payout percentage on normalized FAD for the second quarter is 91%. Normalized FFO dollars increased $0.9 million, or 3%, to $28.7 million in the second quarter, up from $27.9 million in the first quarter. The normalizing items in the second quarter included acquisition costs for real estate assets closed during the quarter, interest related to the timing of the issuance of the 2023 senior notes and concurrent redemption of the 2014 senior notes and the losses on extinguishment of debt. The extinguishment losses are the most notable item in the financial statements of the company for the second quarter at $29.6 million, with an additional $0.3 million that was included in discontinued operations. These extinguishments resulted in the company reporting a GAAP net loss for the second quarter. However, they are adjusted for in computing normalized FFO. Rental income increased from new and recent acquisitions and the re-leasing yield improved again this quarter. We continue to exercise discipline in managing all elements of lease renewals, including rental rate, annual increases, tenant improvement dollars and broker commissions. Three specific lease expirations in the multi-tenant portfolio are responsible for a small second quarter variance in certain operating metrics. Some specialized on-campus space was vacated upon expiration of the lease, as expected, and re-leasing of the space is in progress. Within the same market, a related on-campus hospital tenant renewed 2 expiring leases at lower rates for space that is used for administrative nonmedical purposes. All 3 of these were initially long-term leases in properties acquired by the company in 2004. No tenant improvement dollars were provided in the 2 leases that renewed. The effect of these 3 leases for the second quarter was a reduction in overall same-store revenue, same-store NOI, stabilized portfolio occupancy and the cash re-leasing spreads. Lease rate increases were generally positive in the second quarter. The contractual increases for in-place leases were the annual bumps for the multi-tenant properties were consistent with previous quarters in the 3% range, and the single tenant net lease properties were again in the 2% range. Ignoring the effects of the 3 specific leases I just mentioned, the second quarter re-leasing spread would have been 2.4%. Property operating expenses grew $1.9 million in the second quarter due in part to volume from recent acquisitions and the SIP properties, and in part to increasing property taxes in many markets around the country. Property taxes accounted for about 3/4 of the increase, and while they are expected to rise periodically, local taxing authorities are under growing pressure to generate revenues. The company maintains a rigorous process to monitor, contest and mitigate property taxes throughout the portfolio. Overall, I am pleased with the operating performance of the real estate portfolio, which continues to demonstrate its resiliency and reflects the diligent efforts of the leasing and property management teams. David?

Thank you, Scott. Operator, I think we are ready to begin the question-and-answer period.

[Operator Instructions] And our first question comes from Michael Carroll of RBC Capital Markets.

About a year ago, you guys indicated that the acquisition market was starting to become more attractive and it seems like you really ramped up the pace over the past few months. Is there anything specific that drove this increase?

Mike, this is Todd. I think just generally for us, we've just seen more quality assets come to market. I don't know if you can point to one thing that would say why that is. I think it was more what we were seeing over a year ago that just wasn't meeting our standards. Some of that, you could put on people speculating about long-term trends and cap rates or interest rates. But frankly, we haven't seen a dramatic change lately with some of the volatility. So I think it's just the ebb and flow of what's available.

For the 6 MOBs that are under contract right now or letter of intent, are those all individual transactions?

It's 5 MOBs. But, yes, well there's 2 buildings that are part of the same group. So you're dealing with 2 transactions with the same basic seller. But other than that, it's all 5 separate transactions.

Okay. Have you guys changed, I guess, your acquisition outlook given the recent rise of interest rates over the past few months?

Well, I think from where we -- how see it is that the cap rates are probably not going to react quickly here. I think sellers will not react as quickly as sharply as interest rates have moved around, cost of capital has moved around. So I think we don't see a tremendous change there. I think, really, what you saw was a tremendously low cost of capital that caused some, I think, fairly atypical spreads. Spreads probably moved from the normal range of 50 to 100 basis points to 150 basis points. And I think we're probably back to that 50 to 100 at this point. And I think it remains to be seen going forward if there's any additional sharp changes in the market.

Okay. And then were those HealthSouth purchase options, was that the entire driver of increasing your disposition on volume expectation and cap rate expectation?

Most of it, yes.

Our next question comes from Karin Ford of KeyBanc Capital Markets.

One of your peers reported that they had been seeing in their medical office portfolio more uncertainty among some of their tenants was delaying some decisions as a result of some of the moving parts around ObamaCare. Are you guys seeing that at all in your discussions?

One of the effects that we've seen is some of the physicians have been distracted maybe with the Medicare enrollment plan that they're -- they had to sign up for earlier this summer. I actually think the deadline was at the end of this month. But I mean, I don't know that we've seen huge waves of uncertainty amongst our physician tenants with the implementation of health care reform. I think that was what we saw. What we experienced was more in 2010, 2011, first half of that. We've seen less uncertainty since then.

That's helpful. And I just wanted to ask a little more detail on the leasing movement that caused the revenue reduction in Q2, the expirations and the roll downs. Can you just quantify how much each of those were? And just talk about what the rent was on the roll downs and what it moved to?

Yes, this is Scott. On the 2 that renewed at lower rates, we're talking about 12,500 feet all together. The annual rent reduction, as a result of the roll down, is only about $100,000 a year of rental revenue. It just dramatically affected of the cash re-leasing spread number for the quarter. The other space that vacated was 21,000 feet. It was unoccupied at the last day of the quarter, so it shows up at our occupancy stats, but it is in the process of being re-leased. I don't know what the rental -- off the top of my head, I don't know what the rental rate was on that space, but it should be re-leased here shortly and will replace the revenue.

Okay, that's helpful. And then I appreciate the commentary on new start potential for 2014. How much new development do you guys think you'd be comfortable with as you're thinking about ramping that back up again?

Karin, this is Todd. I don't think there's a certain number that we have. I think it's more just balancing it with what we're seeing -- the trends we're seeing in leasing at our existing 12 properties in stabilization. The starts that we're looking at right now are fairly modest in size, $15 million, $20 million. And I would say that those have leasing in place at a start of 50% or more. So I think it really is a combination of how much leasing is in place, how are we seeing lease-up properties either in that market or across the board. And so, for us, a few development starts a year is plenty. So at that level is not -- it's not going to be significant.

And last question for me. It's just on some of the bigger MOB portfolios that are -- that have been out there being marketed now for a while. I guess Washington REIT said on their call that they had delayed their sale given the capital market uncertainty. Do you still expect there to be couple of large portfolio trades and what you're hearing on that valuation-wise? Are you still expecting valuation levels to be pretty attractive on those?

Well I don't want to comment on specific transactions because we probably don't know a whole lot more than you've heard. But the -- I would say broadly, you probably are going to see some of that same behavior with some pauses on some of the bigger transactions. As you know, we don't typically chase those as hard. We'll look at them and decide if we want to go after them, but we tend to not chase the bigger portfolios as hard unless it just fits for us. So I would say you might see some of that. We've heard about some other larger transactions that decided to pause or delay or just not sell. So you could see some of that. And I think that's just a reflection of the market, as you said. And I think where we really focus is the middle-sized acquisitions of $20 million, $50 million and we see good activity there and not really seeing as much slowdown on that side?

Our next question comes from Jeff Theiler of Green Street Advisors.

I just want to circle back to the cap rate comments. And I guess the cap rates don’t change immediately when there's rises in interest rates. But looking at over the next year or so, with the amount of new product you project coming into the market, I mean, what kind of a magnitude would you expect cap rates to creep up?

Well I think what we're seeing right now is probably more just a slowdown in some compression that you were seeing coming out of in the last 12, 18 months. Cap rates have certainly compressed into the -- for some of the higher-quality assets, bigger portfolios. People's expectations were heading towards 6 and maybe in some cases lower. And I think what you'll see is a pause in that before you'll see uptick the other way. And so it's hard to say how much it will change and how quickly it will change, but I think 6.5 to 7. We're comfortable that we can find acquisitions in that range and maybe it's 25 basis points here or there, but not a tremendous change.

And Jeff, I would say, too, that the type of asset that we typically invest in, the multi-tenant on-campus. I mean, as you know, there's not a huge supply of those coming to market. So I would expect those to be the least sensitive to sort of cap rate changes or you'll probably see it on the edges of the off-campus, the affiliated-type properties. You'll see it probably there first. I don't see it on-campus. Multi-tenant probably the last there.

Okay. And then just on the capital side. In terms of the ATM program, would you expect that just for match funding at this point? Or might you take advantage of the current share valuation to reduce leverage a little bit?

No, we view it as a way to raise equity to fund -- to match fund to acquisitions essentially. So we would be, as acquisitions comes along, pairing up capital with asset.

[Operator Instructions] And our next question comes from Daniel Bernstein of Stifel. Daniel M. Bernstein - Stifel, Nicolaus & Co., Inc., Research Division: You talked a little bit about the change in the attitude of the sellers in terms of bringing some more assets to market. Have you seen any change in the attitudes of buyers? Have you seen any less competitive bidding from buyers? Are you changing the buyer makeup before MOBs? Is it just less private REITs or a less private equity? Just trying to understand if you've seen any changes on the buyer side of the market.

Dan, this is Todd. I think it's a little too soon to tell until you have a little more time and more transactions to see that composition. I would say for now, we continue to see a lot of the same folks of the REITs, a lot of -- a number of these private nontraded REITs. And you always have some of the private players whether it's private equity-backed or pension money. So I don't think we've seen a tremendous change yet. I think over the next few months, we might be able to give some more color on that. Daniel M. Bernstein - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And then on the property taxes, I had a question there in terms -- is there a seasonality in terms of when you pay those property taxes more than another quarter? I'm just trying to think about how the operating expenses are going to continue going forward in the third quarter, fourth quarter.

Dan, this is Scott. I don't think that it's really any notable seasonality to property taxes. We -- as I mentioned in my comments, we have just seen a real emphasis by taxing authorities on boosting the revenues any way they can and property taxes is a convenient way to do it. Some of it is expected because the property value is increasing. For example, in the SIP properties, as the value improves, the taxes will go up on those properties and the rest of it is just kind of random across the board in the markets that we do business in, but not really seasonally. So when we see these assessments come through, we jump on them, each and every one of them. We use consultants for that purpose as well to try to keep them managed and mitigated. Daniel M. Bernstein - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And a question -- I think you may have probably talked about this on prior conference calls. In terms of your view of pre-leasing versus not pre-leasing, and going back to Doug's comment earlier in this call about probably future development starts would be closer to 50% pre-leased, is that really just a function of your demand coming from the hospitals and they're just simply driving that pre-leasing or have you shifted your views at all there?

Dan, this is David. I think its just kind of part and parcel to what the offering is. The hospital really kind of then push off a project until they kind of have internal project commitments or kind of bona fide use or whatever. So I think as long as it's kind of hospital-oriented, most likely it's going to have 50% or more. And I don't think it's necessarily a function of the market as it is a function of the need that they have to get a kind of a certain internal level there to kind of then identify the project and then hopefully, we'll get involved at that point. So it's not necessarily a requirement on our part, but it obviously mitigates the risk and timing. Daniel M. Bernstein - Stifel, Nicolaus & Co., Inc., Research Division: And when you think about the underwriting, is it -- is the target yield and then that pre-released possible based MOB going to be less than, say, in off-campus multi-tenant? How are you thinking about the [indiscernible] in the field?

I think it runs along the whole spectrum. It's 30-year net-net leases, what is the cap rate on that versus what is the cap rate on something that doesn't have any leasing. So I think it's just kind of a function of risk as we see it.

And at this time, I'm not seeing any further questions. I'd like to turn the call back over to Mr. Emery for any closing remarks.

Very good. Well we appreciate everyone being on the call today and we look forward to talking with you again later in the third -- at the end of the third quarter. With that said, we wish you good day.

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