Physicians Realty Trust (NYSE:DOC) Q4 2022 Earnings Call Transcript

Physicians Realty Trust (NYSE:DOC) Q4 2022 Earnings Call Transcript February 22, 2023

Operator: Greetings and welcome to the Physicians Realty Trust Fourth Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brad Page. Thank you, Mr. Page. You may begin.

Brad Page: Thank you, Maria. Good morning and welcome to the Physicians Realty Trust fourth quarter 2022 earnings conference call and webcast. Joining me today are John Thomas, Chief Executive Officer; Jeff Theiler, Chief Financial Officer; Deeni Taylor, Chief Investment Officer; Mark Theine, Executive Vice President, Asset Management; John Lucey, Chief Accounting and Administrative Officer; Lori Becker, Senior Vice President and Controller; and Dan Klein, Deputy Chief Investment Officer. During this call, John Thomas will provide a summary of the company’s activities and performance for the fourth quarter of 2022 and year-to-date performance in 2023, as well as our strategic focus for the remainder of 2023. Jeff Theiler will review our financial results for the fourth quarter of 2022, and Mark Theine will provide a summary of our operations for the fourth quarter.

Today’s call will contain forward-looking statements made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. They reflect view of management regarding current expectations and projections about future events and are based on information currently available to us. These forward-looking statements are not guarantees of future performance and involve numerous risks and uncertainties. You should not rely on them as predictions of future events. Our forward-looking statements depend on assumptions, data and methods that may be incorrect or imprecise and we may not be able to realize them. We do not guarantee that transactions and events described will happen as described or that they will happen at all. For more detailed description of risks and other important factors that could cause our actual results to differ from those contained in any forward-looking statements, please refer to our filings with the Securities and Exchange Commission.

With that, I’d now like to turn the call over to the company’s CEO, John Thomas, John?

John Thomas: Thank you, Brad. Physicians Realty Trust demonstrated resilience throughout 2022 and enters 2023 from a position of strength. Our assets are performing well, demand for our space remained strong, and our balance sheet is well-positioned for outsized external growth. We’re proud of our achievements during the year, including attainment of the highest annual Fed, funds available for distribution for share in the history of the company. The cash growth is supported by record leasing performance. For the year, we executed leases totaling more than one million rentable square feet including over 800,000 feet of renewals and an average spread of 6%. Retention remained strong as 77% and more than 60% of our executed leases had an average annual escalator at 3% or greater.

We remain focused on creating long-term value on behalf of our shareholders. This can occasionally require the selective non-renewal of leases when we believe that the space can be re-let to stronger health system tenants. While this has the effect of hurting total occupancy and same-store NOI growth in the short-term, we believe that these decisions result in a stronger portfolio that delivers superior cash flow growth in the future. During 2022, we increase the amount of space leased to investment grade quality tenants from 65% to almost 67%. And we believe that we continue to have the highest portfolio leased rate of any public medical office building investor. The rapidly changing interest rate environment required us to be disciplined when evaluating external growth opportunities during 2022.

Still, we were able to add to shareholders — add value to shareholders through the transaction we did choose to pursue. In July, we opportunistically sold disposed of our three Great Falls Montana medical facilities at a 4.7% cap rate, generating a $54 million game and an outstanding 16% unlevered IRR. We match this transaction with a $160 million of new investments in 2022 highlighted by our $82 million acquisition of the Calco Medical Center in Brooklyn, New York, at a 5.5% stabilized cash yield. We also continue to work with several health systems to move development and redevelopment projects forward that we expect to proceed in 2023 and generate rent in 2024. Our financial achievements were matched by our accomplishments as they relate to corporate responsibility in 2022.

We made measurable progress toward our goal being a sustainable — sustainability leader across all real estate industry sectors. For the year, we invested in 31 projects totaling $5.6 million that will directly reduce the energy footprint of our facilities, while also enhancing the desirability of these assets to tenants. Thoughtful investments like these are a critical part of our long-term sustainability objectives, including our goal announced in 2021 to reduce our portfolio’s greenhouse gas emissions by 40% by 2030, over our 2018 baseline. Social accomplishments in 2022 include 902 hours of volunteer work, individually and corporately, to the communities we serve, which exceeded our 600-hour goal by over 50%. Doc also provided more than $408,000 to philanthropic fundraising and in-kind donations to community and healthcare provider organizations, benefiting their research and mission initiatives.

In addition, in 2022, we earned recognition for Modern Healthcare as One of the Best Places to Work in Healthcare for the second year in a row, and Top Workplaces Honors from the Milwaukee Journal Sentinel in our headquarters for the fifth year in a row. Our ESG efforts continue to receive recognition at asset and corporate levels. During 2022, Doc assets were certified by IREM under their Certified Sustainable Property program, bring our aggregate count to 38 properties with this designation. Separately, we earned 16 new ENERGY STAR property certifications under their recently relaunched medical office building program, bringing our certification count to 26 and qualifying Doc as a premier member of the Certification Nation’s efforts. We’re also proud to share that we were named to Bloomberg’s Gender Equity Index in January of 2023 as a first-time submitter, distinguishing our work in gender equity in enhanced public disclosure.

We’re thankful to have been recognized in each of these ways and remain committed to maintaining our status as a leader within the healthcare REIT sector on matters of ESG. In a few minutes, Jeff will discuss the strength of our balance sheet and Mark Theine will provide more details on our operating results. Before that, I’d like to take a moment to speak toward our expectations for the year ahead. In 2023, we have set ambitious goals to increase our occupancy at market rate and continue seeking medical office acquisitions and development opportunities. Our development financing pipeline is more extensive than ever, with more than $200 million at cost of opportunities under evaluation and exclusive negotiation. We expect to proceed with many of these opportunities and are targeting stabilized project yields in the 7% to 8% range.

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The acquisition market has not yet stabilized with current and capital market conditions. On market transactions are working around the high six cap rate. Still, with low volumes and a limited financing market. We do not believe the market is reached equilibrium, with our weighted average cost of capital, or the markets cost of capital growth generally. In conclusion, DPhysicians Realty Trust in 2023 with a strong, stable and proven portfolio. Our balance sheet is strong and we remain disciplined and capital deployment, patiently waiting for acquisition and development opportunities that will be accretive to our long term financial goals. We celebrate our 10th anniversary this summer, and we are proud that we have built this company to last for decades to come.

I will now turn the discussion over to Jeff. Jeff?

Jeff Theiler: Thank you, John. In the fourth quarter of 2022, the company generated normalized funds from operations of $61.5 million or $0.26 per share. Our normalized funds available for distribution were $57.9 million, an increase of 5.4% over the comparable quarter of last year, and our FAD per share was $0.24. 2022, our normalize FAD was $242 million, an increase of 10.6% over 2021, and our full year FAD per share was $1.1. Releasing spreads remain strong this quarter at 7%. And we expect the broader economic environment to support our efforts to roll the portfolio’s rent up over time. On the expense side, we’re protected from stubbornly high inflation by our standard triple net lease structure, in which we recover 84% of all operating expenses, which is about 20 percentage points higher than our peer group.

Well year-over-year same store NOI growth was below expectations at 1.5% due to the movement €“ due to the move outs discussed earlier in the year. We see positive results on a sequential basis with quarter-over-quarter same store NOI growing by 1.3%. On the acquisitions front, we had projected minimal acquisition activity in the fourth quarter, and saw that play out with just a handful of strategic transactions taking place, along with some funding on existing loans, patients continues to be the theme here. While cap rates have drifted significantly higher. We are not yet seeing a high volume of deals that meet our quality thresholds at pricing that makes sense in this capital environment. Our cost of capital is extremely competitive right now.

So it isn’t that we are competing against cheaper capital. Instead, we see this as the usual delay that happens when sellers have to adjust to pricing that is less advantageous than they could have received several months ago. Therefore, we are reluctant to put out acquisition guidance at this time. We believe that either cap rates will adjust to historical norms based on current debt costs or we will see improvements in our cost of capital that will create opportunities in the current market environment. We are in constant dialogue with potential sellers and health system partners, and believe we will be in an excellent position to grow the company’s earnings substantially. When this bid ask spread closes. We took steps to bolster our balance sheet further by issuing $74 million of equity in the fourth quarter on the ATM along with another $66 million on the ATM in January.

This place is our balance sheet on a debt to EBITDA run rate of 5.2 times on a consolidated basis, and provides plenty of dry powder for us to utilize at the right time. Finally, a few updates to our 2023 guidance. We expect G&A to increase by about 4.5% at the midpoint to a range of $41 million to $43 million. Current capital expenditures are expected to increase modestly by about 5% at the midpoint to a range of $24 million to $26 million. As we continue to see tenants trade TI dollars for lower renewal spreads. As mentioned earlier, acquisition guidance will be withheld until we have more visibility on how cap rates and capital costs evolve in 2023. With that, I’ll turn it over to Mark to walk through some additional operational details.

Mark?

Mark Theine: Thanks, Jeff. Our tenured asset management, leasing and capital projects teams are united in our focus to serve our healthcare partners. While growing cash flow for our stakeholders. We contributed to these goals in 2022 by delivering record renewal spreads, maintaining retention, and efficiently prioritizing capital project investments in this inflationary environment. These successes are the direct results of our commitments to outstanding customer service and in line with our care core values. Despite the difficult macro environment, we delivered record full year renewal spreads of 6% while maintaining retention of 77%. Importantly, these results were achieved without offering excessive incentives. With full year renewal TI’s totaling just $0.80 per square foot per year.

This efficiency was matched by our capital projects team, who deployed $23.9 million of recurring CapEx in 2022, representing $1.48 per square foot. During the fourth quarter, we continued our positive momentum by achieving renewals spreads of 7% on 141,000 square feet of volume, with leasing costs totaling $0.45 per square foot per year. In addition, new leases totaling 42,000 square feet commenced during the quarter at an average rate of $18.64. Tenant improvement costs on new leases totaling $3.89 per square foot per year remain well within industry averages, demonstrating our commitment to bottom line effective rent rather than headline rate. The weighted average annual rent escalator on this quarters 182,000 square feet of leasing totaled 2.9%, a significant increase against the portfolio average of 2.4% MOB same-store NOI growth was 1.5% in the fourth quarter, below our historical 2% to 3% growth rate due to the 30 basis point decline in occupancy from the vacancies we discussed last quarter.

In total, this 51,000 square feet of lost occupancy across 13.5 million square foot same-store portfolio is largely explained by activity at two specific buildings. First, same-store occupancy continues to be impacted by the strategic non-renewal of suites and an MOB in Minnesota to allow for the construction of a brand new ASC that is currently under construction and leased to the dominant investment grade health system in the market. The new 21,000 square foot surgery center is expected to be completed and paying rent during the third quarter of 2023. Second, 22,000 square feet of vacancy is attributable to an MOB in Pennsylvania, where our historical physician tenants were employed by a hospital and relocated to the hospitals-owned medical office facility at the end of the lease term.

We are making several investments to improve this space. And we have partnered with the local brokerage team with strong healthcare relationships. Overall, we do not view the small amount of negative net absorption to be indicative of market conditions or our potential for internal growth, but rather one-off events that will have a short-term impact on the portfolio. Excluding these two assets, MOB same-store NOI growth would have been 2%. Well, we don’t typically highlight our sequential same-store results, the 1.3% growth in NOI, stable occupancy in 0.5% reduction in operating expenses show positive progress in the impact of our team’s efforts. This is our 19th consecutive quarter of positive same-store NOI cash growth. Again, we enter 2023 with strong leasing momentum.

The macro leasing environment continues to offer an advantage to existing medical office inventory, with quality space in move in condition due to the cost and time required for new construction, especially in markets like Phoenix, Nashville, Atlanta and Dallas where Doc has a strong presence. At the beginning of the year, our leasing and marketing teams launched a comprehensive campaign to increase online exposure of our properties, target key brokers and market influencers and leverage the relationships and knowledge of our in-house property management team. Just two months into the year, our efforts are already yielding results, as tours of vacant space are up nearly 30% year-over-year, and we are trading proposals on over 162,000 square feet of vacant space in the portfolio.

Our leasing and property management teams have a busy calendar of broker open houses to showcase our portfolio and demonstrate new virtual reality technology, which allows prospective tenants to visualize a customized suite and finishes before commencing expensive construction. We have dedicated approximately 60% of our 2023 recurring capital budget of 24 million to 26 million to leasing initiatives that include renovating vacant suites, tenant improvement allowances to retain and attract healthcare providers and general building renovations where there’s a strong leasing activity due to the supply and demand of physicians in the market. Through these collective efforts, we believe that there’s opportunity for an increase in total portfolio occupancy in the back half of the year.

Following a typical three to six months, it takes to design construct and commence a new lease. We expect this positive momentum to also appear in lease renewals, while 2023 scheduled expiration volume remains small at 4.5% of the consolidated portfolio. The market conditions that help contribute to our success in 2022 remain intact. For the full year, we expect renewal spreads to be in the mid single-digits compared to the long-term MOB industry expectations of 2% to 3%. And we anticipate retention to be in line with our historical average of 75%. To conclude, we anticipate that our operational initiatives will lead to improve same-store NOI growth beginning of the third quarter of 2023. While below target same-store performance is frustrating in the short-term.

We believe that long-term value is maximized through thoughtful portfolio management, intelligent capital investments and aggressive leasing initiatives. The thesis for medical office is as strong as ever, and we’re excited to execute on behalf of our stakeholders in 2023. With that, I’ll turn the call back over to John.

John Thomas : Thank you, Mark. Maria, we’re now ready for questions.

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. Our first question comes from Juan Sanabria with BMO Capital Markets. Please go ahead.

Juan Sanabria: Hi. Good morning, and thanks for the time. Just hoping to talk a little bit more about the leasing efforts and the occupancy upside. Can you quantify how much occupancy upside you expect? I think, you said in the back half of the year and would that really be driven by filling current vacancy, or is it more incremental new leasing of space that has been sitting vacant for a bit, and given the — you give the piece parts of re-lease spreads and occupancy a bit? What is the expectations for same-store NOI for 2023?

Jeff Theiler: Hey, Juan thanks a lot. This is JT. I think our ambitious goals this year around both vacancy and really non-renewing lower quality credit tenants with higher quality health system tenants who need to expand into space in their building. So it’s 95% to 96% somewhere in that number is full occupancy, and so our ambitious goal is just to hit those numbers, and so positive accretion for the year, and our compensation goals are tied to that as well. So, we’re, you know, we think that’s very achievable, somewhere in that range, and same-store is a number that is impacted by a small percentage, very small percentage of move out, some of which we caused on our own in sequential quarters and it takes a couple of more quarters to backfill that space with both leases signed, but also more importantly, completing the TI and the commencement of those leases.

So, back after the year, we have expectations for good, solid return to our same-store growth numbers that are historical. First half the year, we’re burdened by the decisions we made, we think the right decisions in the third and fourth quarter of 2022.

Juan Sanabria: Okay. And then I was just hoping for some color on the transactions market and where you see that the bid-ask spreads, maybe in terms of cap rates of where sellers are still holding on what you think is realistic, given your capital costs are generally higher capital across the market.

John Thomas: Yeah. Great question. And we’re seeing a significant movement in cap rates, they’re just not many transactions occurring. Sellers are just holding on, hopeful that we returned to the glory days of 2020 and 2019 from cap rate perspective. But transactions are occurring in the mid-sixes. And we think we have a great cost of capital in the current environment, but that cost of capital still expects needs high sixes to mid-sevens cap rates, depending upon the annual increase reserves in the rents and things like that to execute. So, we think there’s a good opportunity in the back half of the year assuming that market reaches equilibrium in that range. But in the current environment, we’re just not seeing many trades that right quality, right credit, right location that we want to buy, in the mid-sixes.

So we want to see those cap rates move up. And, like Jeff said, we’ve got a balance sheet loaded to execute once we reach equal equilibrium. It’s my word in cap rates with market cost of capital.

Juan Sanabria: Thanks John.

John Thomas: Next one.