Healthcare Realty Trust Inc Q3 FY2020 Earnings Call

Good morning and welcome to the Healthcare Realty Trust Third Quarter Financial Results Conference Call. After today's presentation, there will be an opportunity to ask questions. I would now like to turn the conference over to Todd Meredith, CEO. Please go ahead.

Thank you, Debbie. Joining me on the call today are Carla Baca, Bethany Mancini, Kris Douglas, and Rob Hull. Carla, if you could first read the disclaimer?

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 our Form 10-K filed with the SEC for the year ended December 31st, 2019 and in subsequently filed Form 10-Q. 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, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, 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 third quarter ended September 30th, 2020. The Company's earnings press release, supplemental information, Forms 10-Q, and 10-K is available on the Company's website. Todd?

Thank you, Carla. We are pleased to report positive results for the third quarter. My opening comments this morning will focus on three themes. First, the business for our tenants has rebounded quickly. Second, our properties are performing well, and finally how we are accelerating the pace of acquisitions. We are encouraged to see health systems, frontline healthcare professionals and patients adapting to the demands of COVID while addressing much-needed routine care and surgical cases. This is evident in the activity levels at our buildings including foot traffic, patient visits, and parking, which have all rebounded to 90% or better and are steadily improving. The country is seeing a rise in COVID cases in certain markets, but we expect our facilities to remain open and elective procedures to continue. Public health officials and providers are better equipped and have more experience managing inpatient capacity than back in the spring. They have gained valuable understanding of effective therapies, and the availability of vaccines is on the horizon. Our tenants are now operating at productive and sustainable levels. We credit their resilience to the critical need for specialty outpatient services. Requests for rent deferrals tapered off months ago, and rent collections have returned to normal. We have seen property tours pick up notably, which bodes well for absorption in future periods. While there may be bumps along the way, we expect our portfolio to perform well and steadily improve in the quarters ahead. These positive trends have encouraged us to shift to offense. We are capitalizing on a sizable and growing pipeline, and we have increased acquisition guidance substantially for a second time this year. Ramping up our investment pace has come about organically. Our experienced team has worked proactively in our target markets to source more properties. We are extending our reach deeper in these markets, amassing MOBs in tight clusters. Concentrated scale can help spread costs, but the primary benefit is leveraging our local market intelligence to capture more leasing volume on better terms. We continue to have a strong preference for on-campus multi-tenant MOBs, but we also see the ability to create value by investing in more adjacent and off-campus properties that complement our hospital-centric portfolio. These strategies are enabling us to elevate our acquisition pace on a consistent basis yet maintain discipline and quality. The common link is our relentless focus on dense, high-growth markets and aligning with the strongest providers. We could not have possibly anticipated COVID-19, but many of our target markets such as Nashville, Raleigh, Denver, or Atlanta are benefiting from the trend of migration from some of the largest cities. Through the course of the pandemic, the medical office business has proven essential. Looking ahead, our portfolio is optimized to produce above-average internal growth while exhibiting the hallmark low-risk attributes of the MOB sector. And our efforts to sustain a higher level of complementary acquisitions are translating to more FFO per share and better dividend coverage. Over the long term, a steady rise in demand for outpatient services will ensure our ability to generate attractive growth and solid risk-adjusted returns for shareholders. Now, I'll turn it over to Bethany for additional information on healthcare policy and recent trends.

With an uncertain backdrop of macroeconomic and political factors, healthcare providers have proven quite resilient in 2020. Providers are focused on meeting strong demand for health services and much-needed delayed care. Higher acuity inpatient volume in surgeries have ramped up quickly for hospitals while the lower acuity service lines are expected to normalize in the months to come. If COVID continues to spike, we expect providers to be able to treat patients without shutting down other scheduled care. Hospitals now have adequate staffing, PPE, and better coordination of inpatient bed capacity as well as more use of outpatient facilities. Healthcare providers could also potentially benefit from additional federal assistance whether through a fiscal economic stimulus bill or with the remaining funds previously allotted to them under the CARES Act. For physician offices, HR's tenants have returned to 90% or more of normal volume on average. They have seen a heavy shift back to in-person care even as higher Medicare reimbursement remains in place for telemedicine visits. Physician office hiring in September outpaced every other healthcare sub-sector adding 18,200 jobs. This is more than three times the average monthly hiring for physician offices pre-COVID. After several months of steady hiring, physician offices are now at 97% of pre-COVID staffing level, a sign of strong patient demand, physician revenue growth, and a positive outlook for the coming months. Tuesday's election once decided will have implications for the direction of health policy over the next four years. Several swing states remain under contention, but Republicans are likely to hold the majority in the Senate. If former Vice President Biden prevailed in the presidency with the split Congress, we expect the status quo for healthcare, at least until the next mid-term elections. A more progressive agenda on health policy such as a public insurance option would likely be difficult to pass, which should keep legislation incremental in scope. If President Trump ultimately wins the election, his administration will continue to implement executive orders to increase market competition and consumer choice in healthcare and de-emphasize ACA insurance marketplaces. We generally expect stable Medicaid enrollment and support for Medicare payment rates for providers. In either presidential scenario, a political balance in Congress and the need for bipartisanship present less risk of change for healthcare providers and should result in stable reimbursement levels. On November 10th, the Supreme Court is expected to hear oral arguments in the California v. Texas case to determine if the ACA can remain intact without the individual mandate penalty. We expect the court to consider the law severable from the mandate in keeping with the original intent of Congress for expanded insurance coverage. With any political agenda, the nation's spending on healthcare services will continue to rise, and with the aging of our population, the ability to deliver more specialty outpatient care will become increasingly critical. Healthcare Realty's medical office facilities are strategically positioned in growing markets to enable providers to expand their services and meet greater patient demand. Now, I will turn it over to Kris Douglas for an overview of operational and financial results.

Thank you, Bethany. Performance in the third quarter was strong, rebounding well from the COVID impacts we saw in the second quarter. Healthy rent collections and internal growth combined with accretive acquisitions contributed to normalized FFO per share of $0.41. It is noteworthy that this is $0.01 above a year ago even with almost $0.02 of dilution from the $244 million disposition of the Mercy assets in July. And, looking forward, we're on pace to more than redeploy these proceeds by year-end, which positions us well to sustain meaningful FFO per share growth in 2021. Our ability to grow FFO amid pandemic-related challenges is a testament to our portfolio strength. As expected, we experienced sequential quarterly impacts from the typical third quarter seasonal utility expenses as well as the Mercy dispositions. These were partially offset by nearly 50% increase in parking income over the second quarter. In addition, we benefited from a $1 million sequential swing in COVID rent deferral reserves including a $300,000 release from the reserve in the third quarter. The deferral reserve was reduced given that we collected over 96% of scheduled deferred rent payments and there were no material new deferrals granted. Further, and most importantly, third quarter rent collections were 99%, back to pre-pandemic levels. Remaining deferrals are scheduled to be repaid by year-end. Turning to operating performance. Same-store NOI was driven by 2.4% growth over the third quarter of 2019 for the multi-tenant properties. Same-store multi-tenant NOI growth was enhanced by operating leverage created from quarterly year-over-year revenue growth of 1.6% and operating expense growth of just 0.5%. Building utilization has rebounded from the second quarter lows, but it's still running below pre-pandemic levels. This contributed to the expense growth below our long-term average of 2% to 2.5%. We expect to see a gradual return to typical expense levels moving forward. Our key revenue drivers bolstered multi-tenant performance. In-place contractual escalators of 2.9% and cash leasing spreads of 4.5% drove revenue per occupied square foot to 2.6%. Overall, revenue growth was impacted by a few COVID-related items. First, year-over-year parking income was down $189,000. However, sequentially, parking income bounced back by nearly $400,000 from the same-store portfolio in the third quarter. This is reflective of patient traffic continuing to improve. Secondly, we saw a 60 basis point decrease in occupancy in the last two quarters mainly due to a slowdown in property tours in the second quarter. Tours have rebounded meaningfully in the third quarter indicating considerable pent-up demand. We are optimistic about absorption moving into 2021. It is worth noting that an unintended, but welcome benefit of the slower leasing activity was less second-generation TI spending. This is reflected in lower TI guidance for the year. The lower spending benefits the FAD dividend payout ratio, which we expect to be at or below 90% for the full year 2020. Shifting to the balance sheet, net debt to EBITDA was 4.8 times at the end of the third quarter below our target range of 5 times to 5.5 times, mainly due to the $183 million of cash on hand at September 30th. After we fully reinvest this cash in the fourth quarter, debt to EBITDA will be in the low 5's. We took a number of steps to maintain our conservative and flexible balance sheet. In October, we entered into forward equity contracts under our ATM bringing total available capital from forward equity to over $112 million. Also, we issued $300 million of senior notes due 2031 with a coupon of 2.05%, and called our 3.75% senior notes due 2023. This refinancing extended our average debt maturity to almost seven years and lowered the blended interest rate by over 30 basis points. We now have no material debt maturities until 2024 and no senior notes expiring until 2025. As we look back on the first three quarters of 2020, we are pleased with the resiliency of our tenants and portfolio. Our market selection and asset quality have generated steady internal growth through challenging times. Strong internal revenue drivers indicate this organic growth will continue. In addition, we are well-positioned to fund our growing acquisition pipeline with numerous capital sources available. In summary, strong internal growth, accretive acquisitions, and low leverage position us well for accelerating FFO per share growth. Now, I'll turn it over to Rob for an overview of investment activity.

Thanks, Kris. Healthcare Realty is confidently moving forward with additional investments. This confidence is supported by the resilient cash flows and strong rent collections from quality medical office buildings. As the pandemic unfolded, a number of marketed deals were pulled and many investors hit the pause button. In contrast, we remained active assembling the robust pipeline sourcing one or two buildings at a time. Over three quarters of our pipeline this year has been directly sourced from building owners and relationships we have cultivated over many years. Our focus has been primarily centered on creating concentrations of buildings around leading hospitals serving dense growing populations. Over 95% of our purchases in the last three years have been in markets where we were already invested, with the balance located in a couple of target markets where we see a clear path to invest in more buildings. Since July, Healthcare Realty has acquired seven MOBs for $117 million. These properties illustrate our focus on forming property clusters around leading hospitals. These clusters position us well to leverage local leasing knowledge and provide a diverse mix of options to tenants with varying space needs. Local expertise also helps us identify and underwrite additional investments in the market. A recent example is a multi-tenant MOB purchased in Los Angeles. The building is 100% leased and located adjacent to Huntington Hospital. This growing 503-bed hospital signed a definitive agreement to affiliate with Cedars-Sinai. This is our third acquisition in the last year around this campus, and we have gained line of sight on additional prospects adjacent to the hospital. Another in Colorado Springs is an off-campus MOB next to a building we acquired in March of this year. The investment gives us control of the two-property complex that provides a convenient destination for medical services along a growing commercial and residential corridor. These properties serve as an attractive alternative for tenants that don't require an on-campus presence. And, they are located a short distance from three other buildings we own on two leading hospital campuses. And in Houston, we purchased an MOB adjacent to Memorial Hermann's 397-bed hospital in the Woodlands. The building is located around the corner from our four other MOBs adjacent to this hospital, and is also near a competing hospital where we own two on-campus properties. This acquisition expands our portfolio to seven on and adjacent buildings in the immediate area that total 440,000 square feet. The average cap rate for our recent acquisitions is 5.8%, and we expect to end the year around 5.5%. This aligns with the broader market where pricing for core and core-plus MOBs has remained steady in the 5% to 6% range supported by a diverse group of well-capitalized buyers. We have recently seen an uptick in marketed deals as sellers return after taking a wait-and-see approach during the early period of the pandemic. A couple of larger portfolios are on the market that don't measure up for us. These particular portfolios do not align well enough with our preferences, a greater on-campus mix, robust rent growth potential, and overlap with our target markets. Looking ahead, we have prospective acquisitions totaling $276 million under contract and another $105 million under letter of intent. While some of these may close in early 2021, we fully expect to have the Mercy proceeds and more invested by year-end. We are raising guidance well above our top end from last quarter. 2020 guidance is now $400 million to $475 million. As we approach the end of a solid year of investing, we remain confident that our team can continue building a robust pipeline that will deliver a strong start to 2021 and contribute to meaningful growth in FFO per share.

The first question comes from Juan Sanabria with BMO. Please go ahead.

Hi, it's Juan here. Thanks for the time. Just on the investment pipeline, I just wanted to get a clarification of how the prospects that you're looking for maybe differ in mix between on and off-campus versus your current portfolio, maybe sounded like you're a little bit more apt or wanting to take on more adjacent assets and if so, if you could comment on the relative pricing differential from a cap rate perspective, on the on versus off?

Yes, if you examine our acquisitions this year, most have been adjacent properties, with a few being off-campus. Looking ahead, the pipeline for the remainder of the year will likely consist of a similar mix of primarily on and adjacent properties, along with some off-campus ones. Regarding the pricing differences, there's typically a range of 50 to 75 basis points depending on the market, and in some instances, it may be slightly higher, but generally, it remains within that range.

Juan, I would say that the on and adjacent properties tend to have cap rates that are more similar, with not much difference between the two. The closer a property is to the hospital, the more consistent the distance tends to be, although it can vary depending on the market, as Rob mentioned.

Great, thanks. You mentioned in your acquisition for 2021 that you had various sources of capital. How should we view your perspective on your cost of capital in comparison to current cap rates and your preference for financing through equity or capital recycling as you proceed in 2021, assuming your cost of capital remains consistent?

Yes, we currently have cash proceeds available for redeployment. Our goal is to maintain our leverage in the low 5s after we redeploy this cash. We are assessing this on a blended weighted average cost of capital basis, which is advantageous for us given our ability to acquire assets in the mid 5s range. We plan to use a combination of debt and equity for this purpose. We have a strong position on the equity side, with $112 million available from our forward equity program this year. This will supplement the cash on our balance sheet to support our ongoing pipeline. We are well positioned but also have access to additional capital sources if needed.

The next question comes from Jordan Sadler with KeyBanc. Please go ahead.

Thanks, good morning. Just a follow-up on sort of the last question regarding the pipeline of potential acquisitions, the under contract and the under LOI. Is the mix there heavily skewed as well toward off-campus?

No, I think the mix is heavily skewed in the contracting; mix is skewed toward on and adjacent, not much off.

On and adjacent, okay.

Yes, if you consider the definition of our adjacent, it's within a quarter-mile.

No, I follow that. It looks like a lot of what you guys have done. I caught a nuance in your prepared remarks, Todd, where you mentioned a strong preference for on-campus multi-tenant medical office buildings. I noticed that this aspect of the mix is kind of decreasing, so I'm curious if you're still able to source those on-campus transactions specifically or if it's primarily more about the adjacent ones.

Yes, we are still able to source on-campus properties. Over the past three years, 95% of our acquisitions have been in target markets where we already have a presence. If you look more closely, about 70% of those acquisitions have been around campuses where we are either on or adjacent to those campuses. This shows our success in building tight clusters around campuses where we aim to enhance our presence. Many of our recent acquisitions that you see as adjacent are part of our strategy to create smaller portfolios near these campuses. We can still access on-campus properties, but our approach relies on direct relationships and local knowledge, often acquiring one or two properties at a time. Typically, we buy one property to enter a submarket and then expand from there. This is where our portfolio pipeline strength lies, as we continually purchase properties around campuses where we see opportunities for substantial growth.

That's helpful. I know there is a significant narrative surrounding work-from-home trends for traditional office spaces and users compared to your primary tenancy. How do you approach this in underwriting when evaluating properties near hospitals? Do you think there might be more availability for sale due to challenges some landlords are facing?

I believe that when we examine our underwriting, particularly for the adjacent buildings, there remains significant demand for tenants to be situated on or near the campus. Our data indicates that even during the pandemic, when foot traffic declined due to restrictions on elective surgeries and inpatient services, there has been a substantial recovery. This rebound is evident in our statistics. Therefore, we anticipate ongoing demand for tenants and space not only on the campus but also in the surrounding area, especially as they continue to provide essential higher acuity services that need to be located near the hospital.

I might add.

Go ahead Todd.

I agree with your point. On one hand, you have local and regional investors who may be struggling in sectors like retail due to economic factors or the work-from-home trend. They might consider liquidity from medical office buildings where value remains strong. However, there are also many who want to hold onto these assets since they are performing well, and there's significant institutional demand for investing in medical office buildings. So, it's a balancing act. You’re correct that this situation likely leads to increased availability, and we've certainly benefited from that. I believe this trend will persist for some time.

Jordan, this is Kris. I'll add one thing actually back to your previous question about the on versus adjacent. As we look at that, as Rob mentioned, our definition is pretty tight at a quarter-mile, and if you look at a lot of campuses, frankly walking across the campus could be more than a quarter of a mile. And, so we look at those pretty close to interchangeably and if we look at our performance across our own properties versus our adjacent properties, they're very, very similar. So, I wouldn't read too much into a slight shift in one quarter or even one year of adjacency versus on, they're very, very similar.

That's helpful. And then just Kris, while I have you a clarification just looked at the same-store portfolio page that you guys provided is helpful. Can you just shed a little bit of light on the three assets that were moving out from reposition, the 443,000 square feet?

We have had some changes with our assets. A few were sold, while others are being repositioned. One notable asset is the fitness center in Dallas, which we are currently reconfiguring. It originally spanned over 100,000 square feet, but the new design will reduce it to about half that size. We plan to invest in upgrades for the building and convert the remaining space into clinical areas. Additionally, we had a general office building in Dallas where a multi-floor tenant recently vacated. We are in the process of filling that space with new multi-tenant floors and have already secured a new tenant for 10,000 square feet. There will be some transitional adjustments as we reposition these assets. The fitness center, being over 200,000 square feet, significantly contributes to the changes in overall square footage that you've observed.

The next question comes from Vikram Malhotra with Morgan Stanley. Please go ahead.

Thanks for taking the questions. I know you mentioned we shouldn't read into too much into, kind of, the on versus adjacent. But, I guess it's also one of the few or maybe one of the first time you've actually outlined, kind of, growing the pie so to say, by looking at adjacent and more so off like you mentioned. So I'm just, maybe just higher level, if you can give us a sense of what's the impetus for this change even if it's slightly on the margin. And then related to that, how is your underwriting maybe different for when you look at off-campus versus what you've traditionally looked at in terms of tenants or bumps or any other metric you may be looking at?

Yes, Vikram, I think, it's a good question and I think certainly we would agree it's obvious we are doing a little more adjacent and it's really not so much new, we've actually been doing it for a while. I think what you're seeing is our ability to accelerate that trend and it's really stacking up nicely this year and we're continuing to add those on-campus buildings, but what you're seeing a lot of this year is our ability as Rob described, over 70% of these assets or where we're developing that cluster. Again, that tight ring, quarter mile around the campus and either adding to the cluster of adjacency or our ideal scenario is we have adjacent, we have on, and then as we build, sort of, what I would call the network effect among the tenants and the leasing and the knowledge that we have from being in that flow. All of the sudden we have a sense of what are the right competitive buildings where we see ourselves competing the most, whether that's on adjacent or off. And, so what we often we get in the flow of that information whether it's through brokers or directly ourselves, and the dialog with the hospital and the providers, and suddenly you realize that one building down the street a mile, which is off-campus by our definition is really a strong building and competing well. We like that, let's go look at that, let's go to see if we can get a hold of that building. And, so you develop that knowledge the longer you're in a market the more critical mass you build. And, then obviously the flip side of that is you get some more benefit, just from a cost standpoint, but our view is really it's revenue enhancing play rather than just a cost, because there's a limit to the cost benefits. So, our view is just building out, sort of, that cluster strategy, and the network effect, and it's anchoring it always with some line of sight down the road of getting on campus, and really tethering yourself to the strength of that local submarket, that cluster effect.

Yes, that's actually where I was going, but you've mentioned cluster. So I was trying to get a sense of what you hope to, kind of, enhance in terms of bumps or your rent spreads or then even up from a cost perspective, maybe the overall margin in that specific market. So I'm wondering if you have any anecdotes or experiences to share where you do have clusters, kind of, how some of those metrics may have started to pan out or what the goals are if you don't?

Yes, I think it's early to give you this concrete example of it does, X or Y exactly, but what we are really seeing, I mean, several places, from just all over the place, Memphis, Nashville, Denver all these different places where we own these on and adjacent or we see, if we don't own those, in some cases, where these tenants might be going and where that demand builds and so it gives us that insight, but I think the core of it is what you said it's getting to a stronger absorption trends. That's a way we see to building that absorption, that positive absorption and then translating that to sustaining, sort of, the 3% to 4% cash leasing spreads, potentially more than that in any given period, but over the long run we think that it's a very compelling way to generate those spreads. And again, it's not a new concept. We've been doing it for a while and now we're trying to really aggressively move more of that direction, and so you're seeing it help us sort of accelerate and elevate the pace of our acquisitions and frankly we think it's very sustainable. I mean, we have a strong pipeline going into next year. Rob mentioned the group of properties under LOI and even some of the ones on our contract that may not close; they'll close in the first quarter. So, we'd be off to a great start next year to kind of keep up a pace at least as strong as this year.

Once thing, I might add to that, Vikram. Vikram, I might add to that is over the last five plus years you have seen us selling some off-campus buildings, I would say those are ones that though didn't fit with this, kind of, cluster idea. But at the same time we always said, we weren't going to 100% on or adjacent. We said there are some good properties that we owned and kind of fit this characteristic that Todd is talking about. So, right now we're, call it 10%, 15% that is off-campus, and so if you see us buying somewhere in that range, it will probably stay in a similar range to what we currently have in terms of the overall mix. So, I would say it's all marginal and it's not an overall major shift in terms of what you've seen out of our portfolio, but we do think it can certainly be additive force.

Okay, fair enough. And then just one last one, you've done a great job, sort of, in getting the payout now, as you mentioned hoping to be 90% or lower. I'm just wondering, kind of, if you have updated thoughts you can share when investors might think about or see a dividend increase.

We've made some progress, and as Kris mentioned, we should be at 90% or better for the calendar year of 2020. Some of this is due to the leasing slowdown we experienced after tours decreased in the second quarter, which has helped us this year. We don’t want to get ahead of ourselves, but even if we spend a bit more next year to compensate for this, it's for the right reasons, focusing on occupancy and absorption. We remain optimistic about next year, aiming to comfortably reach the '80s and potentially the mid-'80s. The good news is it's a matter of when, not if. As we prepare our assessment for '21, we'll stay focused on this goal. While I wouldn’t say it’s imminent, it's certainly on our minds, and we hope to achieve it sooner rather than later. However, we need to carefully evaluate the leasing and payout for '21.

Our next question comes from Nick Joseph with Citi. Please go ahead.

Thanks. You gave some details around tour activities. So I'm just curious how you think about that as a leading indicator for ultimately the leasing and kind of what the typical relationship is between those activities and ultimately signing?

Yes, it's Kris. I'll address that. We monitor our leasing and conversion rates closely, and as mentioned, we experienced a decline in the second quarter, which improved significantly in the third quarter. When we average those two quarters, the results are quite similar to what we observed in the first quarter. This gives us a sense of optimism, particularly from insights gathered from our leasing teams regarding discussions with providers and hospital systems looking to advance their clinical plans. We will keep tracking tour activity as we enter the fourth quarter. There is some delay in the initial tours converting into occupancy, but we are encouraged by the strong rebound in the third quarter, which contributes to our positive outlook for the upcoming year.

Thanks. And then just on your tenants. Do you have a sense of how much pent-up demand is still, kind of, unsatisfied from previous lockdown? Are we backing to a generally normal course of business at most of these divisions?

I would say it's not quite back to normal. I think they're still working through it. You have probably experienced in your own lives, if you are trying to get a doctor's appointment, it's still usually a pretty good delay right now. So, I think there is still pent-up demand. I don't think it's terribly high such that it's going to take forever to work through it, but I do think you still are seeing some of that, and I think the biggest bottleneck is just, kind of, being very safe in everybody's practices and making sure you don't crowd waiting rooms and kind of overwhelm the system. So, I think everybody is doing their best to, sort of, keep it safe and do the appropriate volume right now. So, I think it will continue to benefit. It will be a grind here, as we said, we're about 90% plus varies from 82% to 100% across the market. So, I would see that as just grinding higher until we really see, I think we're all sort of looking for some of the trends to improve probably into the spring and obviously the vaccines will be, I think the real moment when, I think you'll have worked through most of that and get back to sort of a run rate, that's 100% or better where we were pre-COVID.

The next question comes from Rick Anderson with SMBC. Please go ahead.

Okay. So, just quickly on the Mercy disposition, would that cap rate be around 5.5%? I'm curious if you're making any profit on that deployment trade or if it's more about a longer-term growth strategy in redeploying those proceeds?

Yes. No, that was a higher cap rate; it was 7.5% cap rate. It was really about the higher rates that we had there and some smaller markets in the single-tenant risk. So, we did have some dilution that was associated with that, but we think from a long-term value, it's still a good trade for us.

Yes, I recall now, and I apologize for that. Regarding the topic we're discussing, is there an indication that people might prefer to be further from or less connected to a hospital due to current circumstances? Or is this not influencing how the market is behaving and your actions in acquisitions?

No, not at all. We absolutely want to be on-campus. What you've seen from us is that we strategically select the markets we want to enter, and as Rob mentioned, over 95% of those have been markets we're already in. We then drill down to determine which hospitals we want to be around, and we've done that well. Currently, we are expanding by looking at adjacency, and it's a very focused approach. So there’s no change in our desire to be on-campus; we definitely want that. Our portfolio is heavily on-campus, and we haven’t seen any concerns there. We’re not noticing different foot traffic or activity levels. The deferral situation in the second quarter didn’t show any distinction between on-campus, adjacent, or off-campus. We are concertedly developing these clusters, and Rob mentioned that 70% of our activities are within the same cluster. The remaining 30% represents our efforts to find the next cluster. This might involve securing a single on-campus building in a new sub-market or perhaps an adjacent property. Our team is continuously assessing the competition and identifying which buildings we should acquire in that sub-market. Typically, it's more feasible to secure adjacent properties first since hospitals often retain ownership of on-campus buildings or those are held by other institutional buyers like us. Thus, obtaining an adjacent building can often lead to future opportunities, and we've laid the groundwork to position ourselves as the best buyer for on-campus facilities.

Okay. Let me consider this from a different perspective. It seems that medical offices are attracting more attention in the current environment for various reasons, such as their proximity to residential areas, which can make people feel safer. I'm not sure how long this trend will continue, but do you think this environment allows for an increase in sales of off-campus properties? Or is there no significant movement in that area?

Well, I would say, as Kris pointed out earlier, we have probably historically sold a fair bit of our off-campus, and it was really going through and identifying, which ones we want to own long-term versus not. And, so we kind of whittled it down to a lot of the off-campus we have, which is again fairly a small percentage. Those are the places where we want to continue to invest and develop clusters in those markets. So, I would say we're not looking at taking advantage of that trade. Now on the margin, may we do that here or there, sure? But, I would say generally we're very comfortable with the off that we have, and I would say you will see that off-campus for us tick up a little, because as Kris said, we're almost 90:10 on an adjacent versus off and so I could see that drifting to 85% to 80% on an adjacent, but we're comfortable there as long as it fits strategically, it's the right demographics that, kind of, plays into our clusters. So we're very comfortable with that mix.

Yes. And Todd, I would just add to that. This is Rob, I would just add to that point about clusters. If you're investing, obviously generally going to see us where we already have a significant on or adjacent presence. So, it's really complementary to that clustering effect. It's not going to be where we're going in and starting to cluster with an off truly off-campus building.

Yes, I understand. This question is for Kris. Currently, your debt-to-EBITDA ratio stands at 4.8, which is below your target. You're looking at a target of around 5.5 for 2021. How does this impact growth? Specifically, if you increase your leverage in 2021, taking into account low interest rates, you could see significant benefits from the next acquisition if it's entirely financed through debt. I'm interested in how much this could influence material FFO growth in the upcoming year.

Yes. Rich, I think the way to think about that is you kind of really have to pro forma for the cash that you have on the balance sheet. So it's kind of I was trying to highlight in my prepared remarks. So yes, we are 4.8 times today, but if you take our $183 million of cash and redeploy that in the mid-5's that debt-to-EBITDA ends up going back into the low 5 times on a debt-to-EBITDA basis. And, so we're really already in our target range of 5 times to 5.5 times. And, so I wouldn't anticipate a meaningful shift in leverage moving forward. I will point out that we did see some benefit to earnings from the refinancing that we did back in October with the new bond issuance, new 10-plus year 2.5-year bond issuance, it's just over 2%, which brought down our blended interest rate by 30 basis points. So, we are seeing some benefit on that, but I would say we're not looking to try to accelerate earnings moving forward by levering up. We plan to keep that leverage there in the low 5's which is frankly kind of where it is today once that cash is redeployed.

The next question comes from Lukas Hartwich with Green Street Advisors. Please go ahead.

It's John here on for Lukas. Thank you guys for the time, and congrats on the quarter. Just, I guess a two-parter from me. I just wanted to get a better understanding of the supply outlook particularly around your cluster markets and where you see kind of the lack of supply coming on? What's your desire there to have stepped in on the development side to fill that need?

Yes, when we assess markets, we begin with our target areas. Identifying a campus to focus on is crucial, as supply is a key factor in this process. We actively seek out the buildings we want to acquire by determining who owns them and then initiating conversations with either the owners or local brokers to build relationships. This approach influences our selection of clustered markets. If we find there isn't enough opportunity to acquire sufficient buildings in a specific market, we will move on to the next option on our list. Regarding development, in tight markets, we often have established connections with local hospitals, which drive our current development initiatives. We aim to develop properties within these clusters when opportunities arise, but our plans are largely determined by the hospitals' needs and growth. For example, our current project, Valley, was a result of our existing relationship with the hospital, allowing us to develop an additional building on campus. We will continue to assess opportunities while expanding these clusters and have a few projects in the works that meet this criteria. In the coming months, we expect to announce a couple of new developments.

The next question comes from Jon Petersen with Jefferies. Please go ahead.

Thank you, good morning guys. A few kind of COVID-related questions, sort of on TIs, they were a little bit lower this quarter, but I was actually just wondering whether, as you talked about renewals or new leases with some of your tenants if they have reconfiguration needs, social distancing, or telehealth or anything like that that would necessitate TIs to go higher going forward.

Yes, on TI, we kind of look at it based on spend as well as is commitments, and our spend is down, but that frankly is because the volume is down a little bit as we talked about because of the slowdown in tours that we saw earlier this year. If you look at our commitments, they're frankly kind of right in the range of what we historically expect, we say renewal is kind of $1.5 to $2.00, more in that $4 to $5 for new leases. So, we're pretty close to that right now. So, we're not seeing a meaningful shift. We're monitoring what may occur with any changes for COVID in terms of space needs. We're not seeing people as of yet making a material shift in the way they're using that space. I think there's a lot of discussion around that and there are things that could be done, and probably also depends on the specifics of the location. People are getting much better at using online check-in, so you don't have to have as many people in a waiting room and being able to turn exam rooms and cleaning and such. And so, we will be on the lookout for that, but we have not seen anything as of yet that would make us change our typical expectations of what our leasing TI commitments would be.

Okay, that's helpful. Yesterday, we unfortunately reached the milestone of 100,000 new cases. I'm curious if you're discussing with nearby health systems about creating additional capacity for them or if there are plans in place for another spike in overcapacity at your neighboring hospitals.

It hasn't returned to what we experienced in the spring, which is positive. However, there are certain areas where we see spikes. Fortunately, this isn't currently affecting our markets significantly. As a result, there's been limited discussion about addressing these issues in a more substantial way. Overall, we're not seeing it right now. The good news is we all went through this in the spring and had a second surge in July in some markets, so everyone feels a bit more at ease about our ability to manage the situation. I say our ability because it's truly the hospitals, and we're supporting them in any way we can. We're feeling positive about it. We even spoke with a few Board Members who lead health systems in different areas, and they feel much more confident now in handling these spikes than they did in the spring. It's encouraging to hear, although it's hard to predict what winter will bring, but so far, things look good.

If I could ask one more question related to COVID. If a vaccine becomes available, I assume there will be a significant number of people seeking to receive it. Does this present any opportunities for you in terms of short-term demand for administering the vaccine?

I believe there will be an increase in demand for low acuity visits, as people take their children to get vaccinated at pediatricians' offices or more likely at internal medicine and family practice offices. We don't have clear insight into how this will all unfold, but I think it will be positive and encourage people to return to normal activities. It will certainly be beneficial, although we don't have any specific details at this moment.

The next question is from Daniel Bernstein with Capital One. Please go ahead.

Hi, good morning. I think you kind of answered this in the last set of questions. But have you seen any difference in, I guess the demand for the size of your tenants? I mean are your tenants looking for any additional space or expansions? I mean, you had a lot of confidence in your ability to increase occupancy over the next 12 months, just from lease, but I'm wondering if tenants are actually asking for more space as well.

I would say generally yes. I mean, we are definitely seeing a fair amount of expansion talk. It's proportionate. I think it's similar to the positive signs for more new leasing and absorption. So, we definitely see that. I wouldn't say it's a 10 times type of consideration, but we are very encouraged by that. And, one place that we've seen a lot of that going on is this redevelopment in Memphis. It is really just kind of growing through expansion and a big driver of that, one part is the hospital, building out their outpatient practices there, but also an orthopedic and surgery center, that is really ramping up. So, very encouraging signs, I would say, on some of that higher acuity demand. And, we think that will translate to some more expansions. But in proportion, just generally more demand.

Okay. Then, I guess it's not related to COVID, you're not looking for more space because they need...

It's primarily about volume. It's not back to normal.

Volume of healthcare needed, okay.

Yes, volume of healthcare, and not just saying we need bigger waiting rooms or anything like that.

Can you provide some insight into the characteristics of the sellers from whom you are looking to purchase assets? Are these primarily hospitals monetizing their assets, or are they private landlords? I am trying to understand if we might see more hospitals selling off assets to reallocate capital, or if the sellers are mainly private entities looking to take advantage of the current cap rates and reinvest elsewhere within their portfolios.

Yes, I mean, I think that's right. I think it's primarily private building owners that are looking to sell. We've talked over the years about hospital monetization and kind of waited for the wave to come, but we're just not seeing that. We had the Mercy assets that we sold that with hospital that they purchased this last quarter, I think there has been another instance that I saw recently were hospital purchased some buildings. So I don't view them as a large source of product now or in the near term.

Okay. Regarding the question about on-campus versus adjacent properties, do you notice any significant differences in occupancy or rate growth between the two? I'm trying to understand if moving to adjacent properties affects the fundamentals of your rate increases at all.

No, I would say, I think Kris alluded to this, we really see a very common pattern between on and adjacent. There are some differences. One thing we tend to see on campus and this is a good thing, but oftentimes you have a strong anchor occupancy not one lease, but a lot of leases with the hospital, and they oftentimes have a right to take or meet terms of third-party leases as those come up, whether it's a new lease or renewal. And so a lot of times these hospitals will backfill or just take space as it becomes available and that's great for us. But, at the same time you're losing a provider, a third-party provider that wants to be around that campus. So, that's a benefit we see with adjacent, is that you get that synergy of, "Hey we can own the building across the street and if we have multiple buildings we can capture that tenant as they look to continue to be around that campus." So, that's certainly a benefit we see, and so we kind of see, again, just slightly different behaviors, but very similar operating trends in occupancy, retention, leasing spreads; all those metrics look very similar.

And these are fee simple right?

Yes. Almost always you would see that be fee simple.

Okay. That's all I had. Thank you very much.

The next question comes from Omotayo Okusanya with Mizuho. Please go ahead.

Yes, good morning. Actually, good afternoon. Congrats on the solid quarter. It looks like you're kind of '21 near-term outlook is pretty solid as it pertains to external growth internal growth as well, and of course potential dividend growth. So the question I have for the team is, at this point what kind of still keeps you worried or up at night, just kind of given there is a lot of positive indicator at this point for your earnings outlook?

Sure. One thing that Bethany mentioned is that there are elements beyond our control. These external factors, particularly related to the capital markets, appear to be stabilizing positively at the moment. The political environment isn't showing particularly negative outcomes, but the uncertainty and lack of visibility have been concerns for the capital markets and the healthcare sector. Now that we have insight suggesting a mixed outcome, it seems likely that the environment will be calmer and less volatile for at least two years, if not longer. This brings a sense of relief, allowing everyone to focus more on their business, growth, and recovery from COVID. While COVID still brings some uncertainty, confidence has increased compared to several months ago. All these factors, combined with our organic efforts and significant progress in building our acquisition pipeline, make us very optimistic about 2021.

Okay. That's helpful, and then just if you could indulge me, if we go down the ACA rabbit hole for a little bit and let's kind of assume ends up sort of kind of that is unconstitutional, the whole thing kind of gets scrapped. How do you guys think about what the potential impact could be to hospitals and hospital systems, which again are your major client base?

Sure. I think obviously you know this and suggested it. It is a rabbit hole, it's speculation. As Bethany kind of described in her remarks, we really do feel very confident that it will be determined to be severable; there's just a lot of precedent on that. Obviously we could be wrong, you never know where it could go, maybe back to the benefit of the split outcome between the administration and Congress and the Senate and the House. I think hopefully what that leads to is a more productive environment that says we have to get some things done, that may show up in the form of a stimulus bill, it could show up in the form of something that would sort of step in if that were to happen, if the ACA were struck down. I think you would see quick efforts from the administration if it's Biden, obviously from the house, but even the Senate to say we've got to do something to cover these lives and shore that up. So, I just think that it's so unlikely that it's probably not worth a whole lot of time on it, but I don't even think that's the draconian outcome.

The final questioner is Sarah Tan with J.P. Morgan. Please go ahead.

Hi, good morning. Thanks for taking my questions. Just one question on my end. I noticed that your proportion of renewal leases with a negative leasing rate increased this quarter, should we be reading into that?

Yes, I would say this quarter is characterized by a mix of outcomes. We experienced a few more negative instances, but we also saw some positive ones, which balanced each other out and reflected our usual performance. On the negative side, one property had an unusual renewal option that was more favorable for the tenant, contributing significantly to the negative spread. If we exclude that property, only 10% of the spreads would have been negative, which aligns with our historical range and what we've typically expected over the long term. The good news is that 31% of the leases were above expectations for this quarter, so the positives offset the negatives. Overall, I view this as an anomaly rather than a trend we would expect to see long term, and I'm still very satisfied with our overall performance.

This concludes our question-and-answer session. I would like to turn the conference back over to Todd Meredith for any closing remarks.

Thank you, Debbie. We appreciate everybody tuning in this morning and showing your interest and your questions, and we will be available today for follow-up or any time. And we look forward to virtually meeting a lot of you at NAREIT. Everybody have a great day. Take care.

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