Healthcare Realty Trust Incorporated (NYSE:HR) Q1 2023 Earnings Call Transcript

Healthcare Realty Trust Incorporated (NYSE:HR) Q1 2023 Earnings Call Transcript May 9, 2023

Healthcare Realty Trust Incorporated misses on earnings expectations. Reported EPS is $-0.23 EPS, expectations were $-0.11.

Operator: Hello, everyone, and welcome to Healthcare Realty Trust First Quarter Earnings Release and Conference Call. My name is Charlie and I’ll be coordinating the call today. You will have the opportunity to ask questions at the end of the presentation. [Operator Instructions] I will now hand over to our host, Ron Hubbard, VP of Investor Relations to begin. Ron, please go ahead.

Ron Hubbard: Thank you, Charlie. Thanks, everyone, for joining us today for Healthcare Realty’s first quarter 2023 earnings conference call. Joining me on the call today are Todd Meredith, Kris Douglas and Rob Hull. A reminder that 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 company’s Form 10-K filed with the SEC for the year ended December 31, 2022, and the Form 10-K filed with the SEC for the quarter ended March 31, 2023. 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 or FFO, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, or FAD, net operating income, NOI, EBITDA and adjusted EBITDA. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company’s earnings press release for the quarter ended March 31, 2023. The company’s earnings press release, supplemental information and Form 10-Q are available on the company’s website. I’ll now turn the call over to Todd.

Todd Meredith: Thank you, Ron, and thank you, everyone, for joining us this morning for our first quarter 2023 earnings call. Healthcare Realty had a really solid first quarter. As expected, robust operating performance from our portfolio is the foundation of our steady results. We’re building on this durable foundation with two strategic initiatives to accelerate FFO growth. First is our leasing team that’s generating tremendous momentum. Converting this momentum to occupancy gains later this year and moving into 2024 will elevate our internal growth over a multiyear period. Second, we’re focused on a return to external growth. We are working on several capital formation initiatives that will lower our cost of capital and drive accretive external growth.

We expect the foundation of reliable performance from our portfolio, combined with these two initiatives to boost and sustain our bottom line growth well beyond the pace investors expect from the low-risk MOB sector. We see a clear path to generating FFO per share growth of 5% to 7% in 2024. This potential is bolstered by long-term rising demand for health care services and health systems are reporting that demand for outpatient services is accelerating. We also see near-term tailwinds that could strengthen our growth outlook including market expectations for softening inflation and lower short-term interest rates in the months ahead. These tailwinds align well with Healthcare Realty’s post-merger strategic initiatives. For much of the last year, we’ve outlined the powerful benefits of the combination with HTA.

First, we’ve increased safety through portfolio scale, diversification and efficiency. And second, we’re elevating growth through market scale, concentrated clusters and expanded relationships that amplify our internal and external growth drivers. It’s important to note that it takes 3 to 5 years to realize the full value of a significant combination like this. We are well on our way, and we have seen significant results in less than a year. Within the first 6 months of the merger, we successfully completed over $1 billion of asset sales and JVs in a challenging market. We realized our full G&A synergies in half the time we expected. And we’ve fully mobilized our leasing team to drive occupancy gains in the portfolio. In a few minutes, Rob will walk you through how we’ve organized our internal leasing team to leverage our external broker network and increase our deal flow.

This will lead to significant occupancy gains. We expect multi-tenant absorption to double in 2024 to 100 basis points to 200 basis points. And we expect this absorption to accelerate same-store NOI growth to a range of 4% to 6% in 2024. This could be even stronger looking at 2025 and beyond. Rob will also share the favorable trends we’re seeing in the debt financing market for MOBs. In a couple of short months, we witnessed cap rates move lower by as much as 50 basis points. We are increasingly seeing cap rates move into the 5s. Next, Kris will share with you how our portfolio performance is tracking extremely well. He will highlight the company’s solid revenue drivers, including embedded escalators, cash leasing spreads, tenant retention and steady occupancy gains.

Kris will also walk you through our 2023 FFO guidance that serves as a baseline for our 2024 outlook. After the remarks from Kris and Rob, I’ll circle back to spend a few minutes on our capital formation initiatives that will reignite our external growth in 2024. With that, I’ll turn it over to Kris.

Kris Douglas: Thanks, Todd. Operating fundamentals were strong in the first quarter. Quarterly same-store NOI grew 2.8%, quarterly revenue increased by 2.7% and operating expenses by 2.6%, marking a return to margin expansion year-over-year. We are focused on maximizing rent growth and occupancy gains to accelerate revenue growth. Annual in-place contractual increases averaged 2.7% led by multi-tenant at 2.8%. And the 1.5 million square feet of leases that commenced in the quarter had future contractual increases of 2.9%. Cash leasing spreads in the quarter averaged 3.1% once again above in-place escalators. And notably, over 70% of leases had a spread of 3% or greater. Year-over-year occupancy increased 50 basis points to 89% for the same-store properties with total portfolio multi-tenant occupancy just over 85%.

We see a meaningful opportunity for accelerating absorption and NOI growth later this year and into next. As Rob will discuss in more detail, we’re seeing significant increases in leading indicators for future absorption. Operating expense growth of 2.6% in the quarter benefited from successful property tax appeals in the fourth quarter. These appeals will benefit year-over-year expense comparisons for the next several quarters. Trailing 12-month operating expenses, net of recoveries, grew at 3%, which is down from 4.6% for full year 2022. Looking forward, inflationary pressure show signs of further easing, which will allow the power of rent growth and absorption to accelerate future NOI growth. Maintenance CapEx trended lower in the first quarter to $24.9 million or 11.8% of NOI.

The FAD payout ratio was 95% for the quarter and 97% for the trailing 12 months. We expect the FAD payout ratio to be in the high 90s in 2023 as we invest in positive absorption. We expect steady underlying fundamentals and growth of the portfolio as well as the potential for lower interest rates to benefit the payout ratio moving into 2024. For example, a 1% reduction in variable interest rates results in almost 200 basis points improvement in our payout ratio. Normalized FFO per share for the first quarter of $0.40 was down $0.01 from the $0.41 per share run rate in the fourth quarter. This was primarily due to higher interest expense on variable rate debt. In addition, we fully reserved $2.4 million of first quarter revenue related to two items.

$1.5 million for three legacy HCA skilled nursing facilities that we expect to sell later this year. Another $900,000 reflects interest income on a legacy ACA mezzanine construction loan. The project in Houston was paused in the first quarter but remobilized in May. The annual impact of the revenue reserves is $0.025 per share. The 2023 normalized FFO guidance range of $1.60 to $1.65 per share assumes no revenue contribution from these two projects. We expect the Houston construction project to be completed and placed into service by the end of 2023 and the three skilled nursing facilities to be sold later this year. With estimated proceeds of $100 million or more from the asset sales and construction loan repayment, the ultimate annual run rate impact is expected to be less than $0.01 per share.

The benefit from the reinvestment proceeds is not included in the 2023 guidance range. The proceeds when received are expected to reduce debt to EBITDA from 6.6 time this quarter back within our target range of 6 times to 6.5 times. Above average same-store NOI growth moving into ’24 will also help to drive leverage lower. As a rule of thumb, every 1% growth in same-store NOI reduces debt to EBITDA by over 5 basis points. For example, 5% NOI growth next year would reduce leverage by over 1/4 of a turn. We also see a tailwind from expected lower interest rates. The forward SOFR curve suggest rates may rise modestly over the next few months and then decline in the second half of ’23 and into ’24. This would augment our expected occupancy gains and expanded external growth.

But even without improving interest rates, we see a path for 5% to 7% per share growth next year. I’ll now turn it over to Rob for more color on our leasing and investment activities.

Rob Hull: Thanks, Kris. First quarter of 2023 marked the first time that Healthcare Realty’s leasing team operated under a common set of practices, incentive plans, technology and full brokerage coverage. From the merger closing through the end of last year, our team was busy integrating the legacy HTA portfolio into our leasing model. We onboarded the top talent from HTA’s leasing team to our platform and at the first of the year, placed them on our incentive program. We also brought on over 35 new third-party brokerage teams that we identified as the best in their markets. These teams will lease approximately half of the legacy HTA square footage with the balance transitioning to our existing brokerage relationships. To maximize efficiency and speed to lease execution, we now have all of our properties on the same CRM platform called VTS, and we are using Healthcare Realty’s streamlined lease documentation process.

The result of our integration work began to flow through during the first quarter of this year. Prospective tenant tours, an early indicator of leasing activity, increased to over 775 in the first quarter, up over 50% from the fourth quarter. A more significant point is that tours in our legacy HTA properties were up over 80% during the same time versus a 25% increase for legacy HR properties. The benefits of our leasing model are beginning to come through. With better visibility on tours, expectations for the timing of new leases and resulting absorption are becoming clear. Our leasing analytics indicate that tours converted to leases about 15% to 20% of the time. The data also shows it takes an average of 4 months to convert a tour to a new executed lease.

And once a new lease is signed, it takes approximately 6 months for a tenant to take occupancy. This tells us our pickup in the first quarter tours should translate to higher occupancy late this year and into 2024. By maintaining two activity consistent with the past 2 quarters, we expect to generate annual absorption of 100 basis points to 200 basis points next year. This comes from our 34.5 million square foot multi-tenant portfolio. The net effect is these gains are expected to add approximately 1.5% to 3% to our baseline annual NOI growth projections. We have illustrated these points on new slides in our investor presentation on Pages 12 and 13. On the broader demand picture, history shows that even with the economy slowing, clinic-based outpatient medical visits remain resilient during times of slower economic growth.

Recently, there have been supportive read-throughs of positive trends from some core profit hospital systems. HTA and tenant reported that outpatient surgical procedures were up 5% to 8% year-over-year compared to a 2% range in 2022. They also reported further moderation in labor costs and stabilizing margins along with continued plans to invest in outpatient delivery settings. These improving demand drivers correlate with the increased tour activity we are experiencing in our buildings. Shifting to the market for MOB investment. Demand is strong. We see both debt and equity investors looking to reallocate the stability and safety of MOBs. On the debt side, we are seeing larger lenders such as Capital One, Wells Fargo and Fifth Third returned to the market with fresh allocations.

All in, debt financing appears to have shifted down into the mid-5s. This, coupled with growing institutional equity interest in the MOB space, has shifted cap rates lower by 25 to 50 basis points in the last couple of months. Upper tier MOBs are now trading in the mid-5s to low 6s. With this expanded interest, we see increasing opportunities to leverage our joint venture relationships to accelerate external growth volume. Our pipeline of clustered acquisition opportunities continues to grow with our greater market scale and deeper health system relationships. These relationships are a rich source for development and redevelopment opportunities. Health systems are formulating capital plans to meet the increasing demand for outpatient services.

In a few recent examples, hospital reached out to discuss the new — the need for new outpatient facilities in growing markets like Phoenix, Houston, Raleigh and Dallas. This year, we are building a road map for increased occupancy gains that will accelerate NOI growth next year. Additionally, strong demand for MOBs along with our greater scale and expanding health system relationships, positions us well for accelerated external growth. The combination of these two will drive meaningful increases in FFO per share. Now I’ll turn it back over to Todd.

Todd Meredith: Thank you, Rob. It’s important to note the merger sparked strong interest among institutional capital partners. They recognize the value of Healthcare Realty’s operating expertise, the scale of our premium platform and the strength of our deep industry relationships. We are meeting with blue-chip investors who’ve earmarked capital for MOBs and want to rapidly scale their exposure. Over the next 6 to 9 months, we intend to see one or more joint ventures with gross asset values between $500 million and $1 billion. We also expect to secure sizable commitments for go-forward investment capital. We will use proceeds from seed portfolios alongside these capital commitments to fund our robust pipeline of investment opportunities.

These new ventures will diversify our capital sources and expand our ability to invest in a broad range of burgeoning outpatient trends. We see the potential for our gross investment volume to exceed $1 billion in 2024 and expand from there. As we look ahead, we view 2023 as a critical inflection point for Healthcare Realty. We are carefully investing the resources necessary to sustain higher annual FFO growth well above MOB sector norms. In 2024, we see a clear path to FFO per share growth of 5% to 7%. We also see near-term tailwinds that could strengthen our growth outlook, including softening inflation and lower short-term interest rates. We are eager to engage with everyone further as we execute our growth strategy. We look forward to hosting an Investor Day in the latter part of 2023.

We’re working on potential dates, and we’ll pull many of you over the next few weeks, including at NAREIT. With that, operator, Charlie, we’re now ready to shift to the question-and-answer period.

Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Michael Griffin of Citi. Michael, your line is open. Please go ahead.

Operator: Our next question comes from Juan Sanabria of BMO Capital Markets. Juan, your line is open. Please go ahead.

Operator: Our next question comes from Nick Yulico of Scotiabank. Nick, your line is open. Please go ahead.

Operator: Our next question comes from Steven Valiquette of Barclays. Steven, your line is open. Please go ahead.

Operator: Our next question comes from Tayo Okusanya of Credit Suisse. Tayo, your line is open. Please go ahead.

Operator: [Operator Instructions] Our next question comes from Connor Siversky of Wells Fargo. Connor, your line is open. Please go ahead.

Operator: Our next question comes from Mike Mueller of JPMorgan. Mike, your line is open. Please go ahead.

Operator: [Operator Instructions] Our next question comes from John Pawlowski of Green Street. John, your line is open. Please go ahead.

Operator: [Operator Instructions] Our next question comes from Austin Wurschmidt of KeyBanc Capital Markets. Austin, your line is open. Please go ahead.

Operator: Thank you. At this stage, we have no further questions. And therefore, this concludes today’s Q&A session. I would now like to turn the call back over to the CEO for any final remarks.

Todd Meredith: Thank you, Charlie, and thank you, everybody, for joining us this morning. We look forward to seeing you at upcoming conferences, including NAREIT, and we’ll be engaging with you about our growth story, but obviously, also the Investor Day that we’re looking put together for later this year. Thank you, everybody.

Operator: Ladies and gentlemen, this concludes today’s call. Thank you for joining. You may now disconnect your lines.