Healthcare Realty Trust Incorporated (NYSE:HR) Q3 2023 Earnings Call Transcript

Healthcare Realty Trust Incorporated (NYSE:HR) Q3 2023 Earnings Call Transcript November 3, 2023

Healthcare Realty Trust Incorporated misses on earnings expectations. Reported EPS is $-0.18 EPS, expectations were $0.39.

Operator: Hello and welcome to the Healthcare Realty Trust Third Quarter Earnings Conference Call. My name is Harry, and I’ll be your operator today. [Operator Instructions] And I would now like to turn the call over to Ron Hubbard, Vice President of Investor Relations to begin. Please go ahead.

Ron Hubbard: Thank you for joining Healthcare Realty’s third 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 September 30, 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 September 30, 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. Good morning from Nashville, and thank you everyone for joining us for our third quarter 2023 earnings call. I would also like to thank those of you who joined us a few weeks ago at our Investor Day in Raleigh. If you did not attend, I would encourage you to go to our Investor Relations section of our website and see the presentation materials and posted videos. We’ve included a short highlight reel as well as long-format videos with the content of the day. The focus of our Investor Day was Healthcare Realty’s competitive advantages of market scale and relationships. We showcased how we’re using these advantages to drive leasing and occupancy gains and we illustrated how our approach enhances long-term growth through the expansion of our market and cluster strategy.

A key differentiator within our strategy is our proven leasing model. Post merger, it took us about two quarters to fully mobilize the internal leasing team and our brokerage partners across the combined portfolio. Leasing momentum picked up quickly in the first quarter of 2023. Now in the third quarter, we’ve generated record new leasing volume of 447,000 square feet. This includes 269,000 square feet at the HTA multi-tenant properties where we have the most upside opportunity. Looking ahead, our current leasing momentum is setting the table for occupancy gains and NOI growth in 2024. Today, we’re providing a road map and occupancy and NOI growth bridge that outlines our expectations for the fourth quarter and full year 2024. The bridge represents both multi-tenant properties, and the total portfolio.

Our single-tenant properties are fully occupied with consistent NOI growth. I’ll focus most of my comments on the multi-tenant properties, where we have upside. As a baseline, our multi-tenant occupancy is currently 85.1% and our year-over-year NOI growth is currently running at 2.3%. In the fourth quarter of 2024, we expect multi-tenant occupancy gains of 35 to 50 basis points. NOI growth is expected to improve to the mid-2% level, but not fully reflective of the occupancy gains since they will be back ended. Looking into 2024 we split our bridge into the first and second half of the year. In the first half, we expect cumulative occupancy gains of 70 to 100 basis points of recurrent occupancy. We expect NOI growth to elevate to a range of 2.7% to 4%.

In the second half, we expect cumulative occupancy gains of 150 to 200 basis points compared to current multi-tenant occupancy of 85.1%. We expect multi-tenant NOI growth to accelerate to the 4.5% to 5.5% range in the second half. Folding in the single-tenant properties NOI growth is expected to be approximately 4% to 5% in the second half of 2024. Occupancy and NOI improvement is expected to build over the next five quarters. What we’re most focused on is reaching a 4% to 5% run rate in the latter part of 2024 providing tremendous velocity going into 2025. I’m confident we have the best team in the industry to deliver this upside. We’re laser-focused on leasing momentum, tenant retention, and expense controls that will drive occupancy and NOI gains in 2024.

Stepping back to the broader context, we’ve done the hard work to merge and integrate two of the largest MOB companies. We are now the safe choice to invest in a high-quality pure-play MOB company. We have tangible operational upside in our sites bolstered by secular tailwinds. MOB fundamentals are sound. Demand is accelerating from aging demographics, the supply-demand picture for MOBs is tightening in our favor and health systems are reengaged and expansion plans as their margins improve. Turning to third quarter results. We’re pleased to have met our expectations on a number of fronts. Normalized FFO was in line with our expectations at $0.39 per share. Same-store NOI growth improved 20 basis points to 2.3% compared to the second quarter.

In-place contractual rent escalators, moved incrementally higher to 2.76%, and cash leasing spreads jumped to 4.8% well above our guidance range. We also sold five properties in the quarter for net proceeds of over $200 million funding our capital requirements and reducing our floating rate debt. These bright spots are counterbalanced by a couple of areas where we have plans to improve. Operating expense growth was 4.8% in the third quarter. This is down materially from the second quarter, but well above where we need to be to meet our NOI goals. We’re actively working on a number of cost reduction initiatives to reduce operating expense growth to a run rate of 2.5% by the end of 2024. Another key area is tenant retention. Third quarter retention of 76% was below our long-term expectation of 80% or higher.

Retention at the HTA properties has been running about 5% to 10% lower than the HR properties. Our team is actively improving customer service and tenant satisfaction to lift tenant retention into our historical range. Tenant survey scores have already improved at the HTA properties, and we expect retention to follow in 2024. After Kris and Rob, I’ll circle back to provide some additional comments before we shift to Q&A. Now I’ll turn it over to Kris to discuss financial results. Khris?

Kris Douglas: Thanks, Todd. We’re pleased to report a steady quarter, with improvements on several key fronts. Normalized FFO per share for the third quarter was $0.39. This was consistent with the second quarter, as seasonal utilities and higher interest expense were offset by G&A savings. FFO for the fourth quarter is expected to grow modestly, generating per share results of $0.39. As a result, we expect full year FFO at the low end of our guidance range. Trailing 12-month same-store NOI increased 2.8%. Year-over-year, quarterly NOI grew 2.3% a 30 basis point improvement over second quarter. In particular, we incrementally improved our rent growth drivers. Annual in-place contractual increases now averaged 2.76%, up five basis points from last quarter.

The improvement was driven by future contractual increases of 3% for the 1.1 million square feet of leases that commenced in the quarter. Cash leasing spreads averaged 4.8%, up significantly from 3% last quarter. Tenant retention was at the bottom end of our expected range. As a result, sequential occupancy was down modestly by 10 basis points. Looking forward, we expect move-outs to moderate which will help drive positive absorption from significant new leasing volumes. As Rob will discuss in more detail, we executed 447,000 square feet of new leases in the quarter. This drove a 30 basis point sequential improvement in the total portfolio lease percentage to 89.2%. Operating expense growth of 4.8% in the quarter was driven primarily by continued labor inflation and janitorial and personnel expenses, which were up a combined 9%.

These two categories comprise 20% of our operating expenses. Excluding them, operating expenses increased 3.7% year-over-year. The higher janitorial and personnel expense was primarily driven by a goal to improve overall service at the legacy HTA properties. We will start to lap these higher comps as we move into early 2024. Together with cost reduction initiatives, we expect to bring overall operating expense growth below 3% in the back half of 2024. Net debt to adjusted EBITDA at September 30 was 6.6 times consistent with the second quarter. Net debt was $112 million lower than June 30 from $209 million of asset sales in the quarter. We have $138 million of asset sales under contract that are expected to close in the fourth quarter. In addition, we currently have $182 million of properties under LOI that are expected to close by year-end or early 2024.

We expect these asset sales to fund our development commitments as well as reduce variable rate debt and overall leverage to within our target range of six to 6.5 times. We’re also continuing to work on a joint venture with SEC [ph] portfolio of existing HR assets. Given the volatility in the market, we announced at our Raleigh Investor Day that we expect the size of a JV to be at the lower end of our target range of $500 million to $1 billion. We expect to generate proceeds of $400 million to $500 million. As interest rates have moved higher over the last few months, cap rates have also increased to the upper 6% to 7% range. Of course, this does not consider the pullback in rates this week. And we’ll have to see how – see how that plays through to debt financing and cap rates moving into 2024.

I’ll now turn it over to Rob to delve further into recent leasing success. Rob?

Rob Hull: Thank you, Chris. We are seeing strong underlying fundamentals in the MOB sector. The supply-demand landscape is tilting in favor of the landlord. On the demand side, demographic secular trends are accelerating and have a long runway. Healthcare providers operating trends are also improving. And what is really beginning to come through is a tightening supply picture. Higher construction and capital costs have created a larger hurdle for new supply suggesting starts will remain lower for some time. This presents a favorable backdrop for improving occupancy in existing MOBs. During the third quarter, our leasing time – our leasing team signed 142 new leases totaling 447,000 square feet a record for our company. This is up 86% over the first quarter of this year.

Almost 70% of these new leases are for properties in our top 15 markets. These same markets represent 60% of the total portfolio. Signed non-occupied leases or SNO leases across the multi-tenant portfolio currently represent 210 basis points of future occupancy that will commence mostly over the next three quarters. This is up from 140 basis points in the first quarter of this year. At the HTA properties, SNO leases represent 250 basis points of future occupancy, up from 150 basis points in the first quarter and a particularly attractive opportunity for occupancy and NOI growth is within our redevelopment properties where we have 630 basis points of SNO lease In addition, our prospective leasing pipeline is currently over 1.7 million square feet, up from 1.5 million that I reported at our Investor Day.

Almost 20% of the pipeline is in the lease-out and documentation phases, another 30% is in the LOI and proposal phases, with the balance in the active turning phase. Collectively, this pipeline gives us about four quarters of new leasing visibility that will drive our occupancy in 2024. The bridge that Todd referred to is provided on Page 19 of our investor presentation that was updated this morning. This multi-tenant occupancy and NOI bridge includes the fourth quarter of 2023 and runs through the end of 2024. In the fourth quarter, we expect to see positive absorption that will mark the beginning of steady gains in occupancy throughout 2024. Cumulatively, these gains are expected to drive occupancy 150 to 200 basis points above our current occupancy level of 85.1% for the multi-tenant properties.

Strong new leasing activity is expected to replenish our snow pipeline as new leases commence. In the first half of the year we expect new lease commencements of about 400,000 square feet per quarter. Over the second half of the year we expect this pace to increase to about 430,000 to 450,000 square feet per quarter. Vacating for footage is the other side of the absorption equation. Move-outs correlate with our exploration schedule. In our bridge, we expect move-outs as a percentage of expirations to be in the mid-to-high-20s consistent with historical averages for both HR and HTA. We project vacates of about 340,000 square feet per quarter in the first half of the year a product of a greater number of expirations during that time. Over the second half of the year we expect this pace to decrease to about 225,000 square feet 325,000 to 290,000 square feet per quarter.

To achieve our occupancy goals preventing move-outs is just as critical as the volume of new lease commencements. I am confident the right people and processes are in place to deliver our targeted occupancy levels. We expect NOI to move into the — NOI growth to move into the 4% to 5% range in the second half of 2024 and set us up for continued success into 2025. Todd?

Todd Meredith: Thanks Rob. Now I’d like to hit a couple of key points before we move to Q&A. First, I’ll comment on our dividend. Our Board of Directors is keenly focused on our upside potential and is 100% committed to maintaining our current dividend. While we expect to have an elevated payout ratio as we invest in occupancy gains we remain extremely bullish on our ability to improve our payout ratio as we look beyond 2024. Second, we want to stress discipline around capital allocation. In this environment we remain net sellers. We’re not pursuing acquisitions we are avoiding new development starts and we’re pursuing only selective redevelopments of existing assets where it makes sense to maximize value. We will continue to meet our current development and funding obligations through non-strategic asset sales with excess proceeds earmarked for debt repayment.

Once we’re comfortably within our target leverage range we will balance further debt repayment with accretive capital redeployment including the repurchase of stock. We now have four full post-merger quarters behind us with the major merger integration work complete. We shifted to the blocking and tackling phase that allows us to deliver operational upside that’s not driven by the interest rate environment. We are focused on accelerating NOI growth through occupancy gains, improved tenant retention and operating expense control. We remain committed to achieving NOI growth in the 4% to 6% range. We expect to elevate our NOI growth run rate throughout 2024 reaching the 4% to 5% range in the second half. This gives us tremendous velocity going into 2025.

With the occupancy and NOI bridge, provided today, our aim is to create a heightened sense of visibility for investors and accountability around our goals and objectives both internally and externally. We look forward to discussing this further, our bridge and road map with many of you in the coming weeks. Thank you for listening this morning and we’ll now turn it over to the operator for our Q&A portion of the call. Harry?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question today is from the line of Michael Griffin of Citi. Michael, your line is now open. Please proceed.

Unidentified Analyst: Great. Thanks. This is Aubrey Paris [ph] on for Michael Griffin. Kris, I know you touched on this in your opening remarks, but can you expand on how operating costs are trending versus your expectations? And if you could just touch on the cost saving initiatives you’re undergoing that would be great. Thanks.

Kris Douglas: Yes. They are still elevated compared to where we like them long-term. We’ve made some improvements since the last two quarters, but still higher than we like to see. As I mentioned a lot of that has to do with inflationary items on the Janitorial and personnel side. And some of that was known given the fact that we were attempting to improve some service levels. But we’re going to be looking throughout the cost structure at ways that we can bring down costs. We’ll also start to lap some of those comps that we had from last year as we improve the service level. So with that we do see that operating expense is trending lower as we move into next year, but likely looking more towards the back half of the year before we can get back to more historical levels below 3%.

Unidentified Analyst: That’s helpful. Just for a quick follow-up. Just wondering what are retention rate is assumed in the occupancy and NOI bridge that you provided in the deck?

Rob Hull: Yeah. We use move-outs as a percentage of expirations. And it was — the rate that was used in the deck was the mid to high 20s for the different levels on a move-out percentage, yes, it’s correct.

Unidentified Analyst: Got it. Thanks. Very helpful. That’s all for me. Thank you.

Operator: Our next question today is from the line of Connor Siversky of Wells Fargo. Connor, your line is open. Please proceed.

Connor Siversky: Hi, there. Thanks for taking the question. Just thinking about the 2024 guide figures that you have in the presentation and in terms of leasing, how should we be looking at new leases or the spread between new leases versus natural move out such that you can hit those occupancy figures and get to that 4.5% to 5.5% range?

Todd Meredith: Yeah. Connor this is Todd. I would say, if you look at our bridge that we provided in our investor presentation we laid that out pretty clearly and I think Rob certainly walked through that. We’ve talked about the new leasing volume that we reached this quarter about 450,000 feet. That’s a level that you see in our bridge starting to come through really throughout 2024. We really hit that stride in the second half, but you see it building from the high 300,000 square foot level of new leases in the fourth quarter, next quarter, and then starting to move into the 400,000 range in the first half and then towards that 450,000 range per quarter in the second half. So it’s really — that’s a critical level and we mentioned at our Investor Day, this third quarter leasing volume really puts us on plan at a level that really starts to produce the amount of new leasing that will drive this occupancy gain.

But as was just asked and as Rob touched on, the vacate numbers, the move-outs are just as critical. And frankly in the third quarter, as I mentioned in my remarks, it was — the move-outs were higher than we needed. So our retention levels were not quite where we need them to be. So, as we discussed, we are putting a lot of measures in place to increase our tenant retention. So we expect that to play through. That’s clearly been a weakness on the HTA side, which we’ve talked about and we’re already seeing improvements. We’ve done surveys and are seeing nice improvements there. So we expect that to move into where our move-outs are running in line with our expirations more in the mid to high 20% range. And when you do that math, you come out to these occupancy gain levels, which as we show in our bridge is 150, 200 basis points from our starting point at the end of the third quarter.