Healthcare Realty Trust Incorporated (NYSE:HR) Q4 2022 Earnings Call Transcript

Healthcare Realty Trust Incorporated (NYSE:HR) Q4 2022 Earnings Call Transcript March 1, 2023

Operator: Thank you for joining. I would like to welcome you all to the Healthcare Realty Trust Fourth Quarter Earnings Conference Call. My name is Brika, and I’ll be your event specialist operating today’s call. Thank you. I would now like to hand the call over to our host, Ron Hubbard of Investor Relations. Sir, you may begin your conference call.

Ron Hubbard: Thank you, Brika. Thank you, everyone, for joining us today for Healthcare Realty’s fourth quarter 2022 earnings conference call. Joining me on the call today are Todd Meredith, Kris Douglas and Rob Hull. A reminder that, except for 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 Form 10-Ks filed with the SEC for the quarters ended March 31, June 30 and September 30, 2022. 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 measures, 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 December 31, 2022. 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 for our fourth quarter 2022 earnings call. I’ll start by pointing out that we’ve successfully achieved two key merger integration objectives. First, in January, we completed the final portion of our planned asset sales to fund the merger-related special cash dividend. It’s worth noting that we executed these sales at our targeted cap rates. Second, we realized our full annualized G&A savings in the fourth quarter. That’s in half the time we originally expected. The primary driver was reaching our projected staffing levels. Most importantly, we fully transitioned to the Healthcare Realty leasing model with full brokerage coverage across our portfolio. Later, Rob will expand on how this is already building leasing momentum.

I would like to commend my Healthcare Realty colleagues for their incredible effort and dedication to accomplishing these milestones. Looking to 2023, we expect to return to a steady state capital recycling mode. Given the current state of capital markets and the completed dispositions, we expect to optimize the portfolio at the edges. Proceeds will be reinvested primarily into our redevelopment pipeline. This is our top priority for 2023. We expect the acquisitions to be modest on these selected properties to protect our market position and cluster strategy. With market scale and deep relationships, we are well prepared to ramp up accretive acquisitions when capital markets improve. The secured financing picture has improved notably since last November.

This is important because secured financing drives nearly 2/3 of MOB buying power. Both underlying rates and spreads have improved. All-in rates improved more than 100 basis points from the peak last fall and now are about 50 basis points better. The breadth of lenders remains tight but quality properties are getting financed. Rates are now trending in the high 5s. This improved financing has pulled MOB cap rates a bit lower since November towards the 6% level. MOB fundamentals remain favorable with robust demand for outpatient facilities. Healthcare is one of the largest, most stable and fastest-growing employment sectors. Healthcare employment grew nearly 4% year-over-year in the most recent report, with ambulatory services growing even faster.

These employees are coming to work every day in one of our buildings. We also see green shoots that inflation pressure and labor costs are easing, especially for health systems. We’re talking to physician groups, who are committing to more space today and health systems that are actively planning for more rapid outpatient growth in the near future. For the fourth quarter, we reported strong results and key operating metrics. Same-store revenue grew well above 3%, propelled by healthy rent escalations, cash leasing spreads and occupancy gains. Kris will get into more detail in a moment. In 2023, we expect same-store NOI growth to trend higher above 3%, assuming moderating expense growth and steady occupancy gains. Leasing momentum is solid with over 600,000 square feet of signed leases yet to take occupancy.

This equates to roughly 150 basis points of gross absorption. We aim to capture most of this in the first half of ’23, boosting the current trend of 50 basis points of net absorption. Development starts are another clear sign of positive leasing demand. Healthcare Realty has the largest and most visible pipeline in the MOB sector. Our active pipeline is over $230 million, and our near-term prospective pipeline is roughly $350 million. And behind this, we have a long-term embedded pipeline of $1.7 billion. This expanding pipeline is the benefit of the larger Healthcare Realty platform, deeper relationships and significant market scale. We are in a leadership position to secure more development projects with major health systems. Looking ahead, Healthcare Realty’s long-term outlook is bright.

Our primary focus post-merger is operational execution to accelerate same-store NOI growth. With a well-scaled platform, we expect to capture outsized absorption and rent growth. We expect higher-yielding development projects to drive our external growth in the near term. And as inflation moderates and interest rates stabilize, we’ll add accretive acquisitions to bolster our growth profile. Now I’ll turn it over to Kris to provide a review of our financial and operating results.

Kris Douglas: Thanks, Todd. We made tremendous progress on integration in the fourth quarter. Asset sales to fund the merger special dividend were completed, and our targeted annualized G&A savings was realized. Normalized FFO for 4Q was $0.42 per share, in line with the third quarter. The FFO results include normalization of $12 million in noncash interest expense in both third and fourth quarter for merger-related fair value adjustments. We were encouraged by analysts and investors to normalize for this item to make results more comparable to peers. Normalized FFO in the quarter was impacted by a $5.2 million sequential increase in cash interest expense from higher rates on floating rate debt as well as higher average debt balance.

This was partially offset by a $4.5 million sequential reduction in G&A. We have now realized $35 million of annualized cost reductions compared to premerger combined G&A. There are still some marginal synergies yet to be realized over the next two quarters, but we expect these to be offset by normal G&A increases. $462 million of asset sales were completed since the end of the third quarter to finalize the full funding of the $1.1 billion merger special cash dividend. Run rate FFO including the timing impact of the asset sales is $0.41 per share. The run rate FFO and FAD shown on Page 5 of the supplemental do not include any impact of additional changes in interest rates or growth in portfolio cash flow. Operating fundamentals were once again strong and highlight the growth potential of our properties.

Photo by julia zyablova on Unsplash

Same-store NOI for the year increased 2.5%. Year-over-year quarterly same-store NOI growth was even higher at 2.7%. The contribution from the company’s share of JVs improved both quarterly and annual growth by 10 basis points. The quarterly NOI growth was driven by a 3.3% increase in revenue offset by a 4.6% increase in operating expenses. The year-over-year quarterly revenue growth was comprised of a 2.8% increase in revenue per occupied square foot and a 50-basis-point improvement in average occupancy. We continue to focus on maximizing cash leasing spreads, occupancy and in-place contractual increases. Cash leasing spreads in the quarter averaged 3.5%, up from 2.9% in the third quarter, with 80% of the leases having a spread of 3% or greater.

Sequential occupancy increased 59,000 square feet or 10 basis points to 89.3% for the same-store properties. Total portfolio occupancy is 87.7%, providing meaningful opportunity for continued absorption and NOI growth. Annual contractual increases are now 2.81%, up from 2.64% last quarter. The improvement was the result of higher increases on leases with CPI-based escalators and 2.9% average future increases for the leases that commenced in the quarter. The improvement was also bolstered by the sale of our lower growth properties, which had annual escalators below 2.4%. Operating expense growth of 4.6% was down substantially from the 7.9% in the third quarter. We benefited in the quarter from several successful property tax appeals. Excluding their impact, expense growth is running approximately 6%.

Operating expense growth remains elevated compared to historical norms, but inflationary pressures show signs of easing. This will allow the power of our revenue drivers and occupancy absorption to help drive improving NOI growth through 2023. Maintenance CapEx increased in the fourth quarter over the previous three quarters, which is consistent with the seasonality we typically experience. To give a better picture of capital expenditure trends, we provided on Page 5 of the supplemental the combined company trailing 12-month maintenance CapEx spend. Based on the Healthcare Realty annual dividend of $1.24 per share the pro forma 2022 FAD payout ratio was 94%. We expect the FAD payout ratio to be in the high 90s in ’23 giving capital spending for expected occupancy absorption as well as higher average interest rates year-over-year.

As interest rate increases moderate, the underlying fundamentals and growth of the portfolio will drive the payout ratio lower. Run rate pro forma debt-to-EBITDA at year-end, including the impact of January asset sales was 6.4x. Target leverage continues to be in the low to mid-6s. We expect leverage to trend towards the lower end of this range from underlying portfolio growth. With minimal near-term funding needs, we will look to additional asset sales to fund limited acquisitions and steady development funding in 2023. Since the end of the third quarter, we have entered into $600 million of new interest rate swaps in anticipation of the $300 million of swaps that expired in late January. The net result is pro forma fixed rate debt at approximately 85%, which is where we expect to remain for the near term.

As we wrap up 2022, we’re pleased to have completed the funding of the merger special dividend as well as achieved our targeted synergies ahead of schedule. In 2023, we are poised to unlock the operational benefits of our scaled and recession-resistant medical office portfolio. Now I’ll turn it over to Rob for further updates on investment and leasing activity.

Rob Hull: Thanks, Kris. With the completion of our merger-related sales, we expect additional dispositions of $200 million to $300 million this year. These sales will further optimize the portfolio’s long-term growth expectations. Proceeds from our dispositions will fund our active development and redevelopment pipeline and a minimal amount of acquisitions like those we completed in the fourth quarter. Our primary focus for investing right now is development and redevelopment. For development, we target returns of 100 basis points to 200 basis points above stabilized acquisition cap rates. Redevelopment is expected to produce richer returns in the 8% to 11% range. In the fourth quarter, one new development advanced from our perspective to active pipeline.

This 100% leased $25 million project is the first of a 2-phase MOB development in Orlando. This year, across our $235 million active pipeline, we expect to fund approximately $25 million to $30 million per quarter. We are seeing increased opportunities for developments through a greater market presence and a fresh start to newly inherited health system relationships. An example is in Phoenix, where we now own 35 buildings filling 1.5 million square feet. This market scale places us at the center of leasing activity and transaction deal flow. We are working on a joint venture opportunity with a reputable developer for a 100,000 square foot MOB. The project of over $50 million is adjacent to a 120-bed hospital in an area undergoing explosive growth.

The developer solicited our participation in the project given our sizable presence in the market and our relationships with multiple health systems. The development is 50% pre-leased with a clear path to 75% before construction begins. We added this project to our prospective development pipeline this quarter. Our much larger portfolio is a rich source for redevelopment opportunities. As an example, we are working on the redevelopment of two on-campus 60% occupied MOBs in Houston that came to us from HTA. I recently traveled to meet with senior leadership to renew the relationship with the hospital. They shared plans to increase the hospital bed count by almost 50% with the addition of a new acute care bed tower. Our team shared a $20 million plan to redevelop our buildings.

We all agree that collaborating on these projects will reinvigorate the campus. The fresh start will attract physicians and create a great location to house new hospital services. We expect to move this project to our active redevelopment pipeline later this year. Turning to leasing. During the quarter, we completed the onboarding of 100% of the legacy HTA portfolio to third-party brokers. Our brokers, combined with improving relationships with our new health system partners, will drive leasing momentum. What is really exciting is that we are already seeing early signs of improved leasing activity. A great example is prospective tenant tours. Across the portfolio, tours in January jumped 60% compared to the last three months of 2022. And in a local example, our brokerage team in Phoenix recently used seven of their brokers to conduct 11 tours in one day.

Such a broad and efficient coverage is a testament to the value of a strong brokerage team. In contrast, under HTA’s in-house model, it would have been difficult to complete these tours in a week, allowing time to pass and interested parties to go elsewhere. Looking ahead, our Phoenix team is confident they can execute new leases in the next couple of months that will more than double our leased but not yet occupied space in this market. Similarly, I was recently talking to our Dallas-based Director of Leasing, who was energized by the momentum created from the brokers we added to our legacy HTA assets. He mentioned that the rate of monthly tours on one campus has doubled since adding them. More importantly, our brokers quickly sourced a sizable lease through their established provider network.

With this momentum and leases currently in build-out, we expect gross absorption in this market to increase almost 350 basis points in the near term. As we look to 2023, success on both the development and leasing fronts will serve as the foundation for accelerating growth. Operator, we are now ready to open the line for questions.

See also 11 Most Profitable Energy Stocks and 25 Largest Energy Companies by Market Cap.

Q&A Session

Operator: The first question we have comes from Austin Wurschmidt of KeyBanc.

Austin Wurschmidt : Just first question, kind of hitting a little bit on some of the strategic objectives looking forward. I mean 2023 same-store NOI growth guidance of 3% to 4% has some implied acceleration from the fourth quarter, and it’s kind of consistent with what you’ve talked about. But I’m curious what your latest thoughts are on the time line of getting you into that high end of that 3% to 5% same-store NOI growth opportunity that you guys have talked about following the merger. Is 2024 a reasonable timeframe to think that you could see that continue to accelerate?

Todd Meredith : Thanks, Austin. And Brika, if you don’t mind, we’re having a little bit of a quiet volume. So if you can add some volume for audience? That would be great. But Austin, for your question, I think just to clarify, our guidance for ’23 on same-store NOI growth is 2.5% to 3.5%. But directionally, Austin, I think the point here, and I mentioned it in my remarks, that we’re seeing a lot of strong trends in place, obviously, on the revenue side, through occupancy gains, rent growth that are really pushing that revenue equation higher. And so we see that translating in ’23 kind of throughout the year from the lower end of that range where we finished ’22 to sort of the higher end of the range through the balance of ’23.

So I think our view is we’re heading north of 3% later in the year. And that certainly bodes well for the trend going into ’24, building off that momentum. So I think, again, 2.5% to 3.5% for the year, but sort of a build in that range throughout the year.

Austin Wurschmidt : Sorry about that. I was looking at the cash leasing spreads.

Todd Meredith : Yes, that’s certainly an important driver rather a big contributor.

Austin Wurschmidt : And along similar lines, you’ve talked about the upside from driving occupancy. You noted some of the pipeline that you’ve got today with a significant portion of that opportunity across HTA. So how did you embed some of that — some of those upside — some of that upside and drivers within the same-store NOI guidance? What are some of those puts and takes, I guess, that’s — that we should think about? Any near-term headwinds that are offsetting some of these benefits today as that starts to build over time?

Kris Douglas : Yes. No, I think you can kind of see what we’re trying to get through with the different components of the same store. We are expecting to get some absorption as well as some improvement and our cash leasing spreads versus what we saw in 2022 as we bring the combination of the two companies together. One piece that is it’s a bit of a headwind compared to historical experience, but an improving picture from where we’ve been in 2022, our operating expenses. As I talked about, operating expenses are now for us running around 6%. That’s still elevated from our typical norm of 2% to 2.5%. But we are seeing some signs that, that could start moving in the right direction, but we don’t anticipate that we’ll get all the way back to that 2% to 2.5% in 2023. But we think it will start moving in the right direction, which will allow those different components of the revenue drivers to shine through and drop to the bottom line on NOI growth.

Operator: Your next question comes from Nick Yulico of Scotiabank.

Nick Yulico : Great. First question is just in terms of interest expense, I know you didn’t give guidance on it specifically, but I wanted to just see if you — if there’s any way we can get a feel roughly for how, I guess, cash interest expense without the mark-to-market on the debt could look like this year.