Earnings Call Transcript - HR Q2 2024

Operator, Operator

Good afternoon. Thank you for attending the Healthcare Realty Second Quarter Earnings Conference Call. My name is Cameron, and I'll be your moderator for today. All lines will be muted during the presentation portion of the call with an opportunity for questions-and-answers at the end. I would now like to pass the conference over to your host, Ron Hubbard, Vice President of Investor Relations. You may proceed.

Ron Hubbard, Vice President of Investor Relations

Thank you for joining us today for Healthcare Realty's second quarter 2024 earnings conference call. Joining me on the call today are Todd Meredith, Kris Douglas, and Rob Hull. A reminder that except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risks and uncertainties. These risks are more specifically discussed in the company's Form 10-K filed with the SEC for the year ended December 31, 2023. These forward-looking statements represent the company's judgment as of the date of this call. The company disclaims any obligation to update this forward-looking material. The matters discussed in this call may also contain certain non-GAAP financial measures such as funds from operations or FFO, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, or FAD, net operating income, NOI, EBITDA and adjusted EBITDA. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release in the quarter ended June 30, 2024. The company's earnings press release, supplemental information and Form 10-K are available on the company's website. I'll now turn the call over to Todd.

Todd Meredith, CEO

Thank you, Ron, and thank you everyone for joining us today. Healthcare Realty had a strong second quarter. We are making notable progress on our capital allocation objectives and we are accelerating our operational momentum. For the second quarter, normalized FFO was $0.38 per share. This was impacted by the previously disclosed Stewart revenue reserve. Without the reserve, our results were $0.39 per share. Based on strong execution and momentum generated in the first half, we increased our full-year 2024 FFO guidance midpoint by $0.005. The increase would have been about $0.01 more without the reserve. In terms of capital allocation, we expect to generate more than $1 billion of proceeds from completed or planned JVs and asset sales. Our new JV with KKR is already growing, and we recently announced an expansion of our existing JV with Nuveen. We expect about 70% of total proceeds to come from asset contributions to these JVs. To redeploy this capital, we moved early in the second quarter repurchasing stock at discounted levels. To date, we've repurchased almost $300 million at an average supplied cap rate of 7.5%. With JV contribution and asset sale cap rates at 6.6%, this equates to 90 basis points of positive spread or well over 100 basis points, including JV fees. Looking ahead, we will remain opportunistic and continue repurchasing equity if it's accretive. Turning to operational momentum. We're seeing strong leasing trends and accelerating occupancy gains. The second quarter marks the fourth consecutive quarter with more than 400,000 square feet of new leases signed, and our first half multi-tenant occupancy gain of 55 basis points was solidly above the top end of our first half bridge guidance. We expect this momentum, the strong momentum to continue into the second half and 2025. I'm especially pleased with our second quarter retention. This is our second consecutive quarter at the 85% level, which has improved materially from the mid-to-high 70s last year. Higher retention comes with the benefit of avoiding lost rent from downtime and avoiding higher tenant improvement dollars to re-tenant vacant space. I want to commend our leasing and operations teams. Their efforts to step up service levels and reduce move-outs are really paying off. Our operations team is also successfully controlling operating expenses. Second quarter expenses declined year-over-year and are nearly flat for the first half. We expect growth in operating expenses to be contained in the 2% to 3% range for the full year. It's worth noting our net operating expenses are expected to grow well below 2% in '24 after taking into account tenant reimbursements. As a result, we are seeing meaningful margin expansion. The combination of strong occupancy gains and well-controlled expenses is translating to higher NOI growth. Without the Stewart Reserve, same-store NOI grew 3.5% in the second quarter, and total multi-tenant NOI grew 3.9%. Both of these are at the high end of our guidance ranges. With strong momentum in the first half, we are steadily driving multi-tenant NOI growth towards the 5% level. Turning to maintenance CapEx. Spending on TI and commissions is elevated as expected based on strong new leasing volumes. This investment in positive absorption is relevant in enhancing capital. In terms of capital allocation priorities, this is our highest return on investment by far. Excluding this revenue-enhancing capital, which we estimate to be $20 million to $25 million this year, our dividend is expected to be fully covered going into 2025. Looking at the balance sheet, we expect our leverage to trend lower. Once we complete the announced JV and asset sale transactions, leverage is expected to be approximately 6.4x. And we expect leverage to improve further going into 2025 as occupancy gains flow through to higher EBITDA. Now over to Kris to discuss results, guidance and the balance sheet.

Kris Douglas, CFO

Thanks, Todd. The first half of the year has been marked by strong operational and capital allocation execution. Normalized FFO per share for the quarter was $0.38, excluding the previously disclosed $3 million Stewart revenue reserve, FFO per share was at the upper end of our quarterly guidance of $0.39. Same-store NOI for the quarter without the revenue reserve improved 50 basis points sequentially to 3.5%. Multi-tenant NOI growth improved to 3.9%, which is at the upper end of our bridge expectations for the first half of the year. The strong NOI performance was driven by better-than-projected absorption and expense controls. Revenue growth benefited from 122,000 square feet of sequential multi-tenant absorption and 2.9% cash leasing spreads. The absorption outperformance came from a combination of better-than-planned new lease commitments and materially lower move-outs. Tenant retention for the quarter improved to 85.5%, up from 79.3% last year. Cash NOI margins improved 50 basis points sequentially and 70 basis points year-over-year as a result of the occupancy gains and strong expense controls. Year-over-year quarterly operating expenses decreased almost 1%, and net of recoveries were down almost 3%. This came from discipline and proactive efforts, especially on labor cost and property taxes. Labor costs declined 2.0% year-over-year. Property taxes decreased 1.5% from successful property tax appeals late last year. We will lap some of these benefits in the second half, but expect total full-year operating expenses to be well below 3%. Operating expenses at or below our in-place contractual escalators of 2.8% less the full impact of absorption dropped to the bottom line and improve overall NOI margins. Turning to capital allocation. JV contributions and asset sales have generated $400 million of proceeds year-to-date. The proceeds funded existing capital commitments and $295 million of stock buybacks. The average repurchase price was $15.89, representing a 7.5% implied cap or approximately 20% discount to NAV. For the year, we expect over $1 billion in total JV and asset sale proceeds. This will fund $200 million of existing capital commitments and $800 million of combined debt repayment and share buybacks. The $800 million of capital allocation proceeds are expected to generate over $0.001 a share of accretion in 2024 and over $0.025 annualized. FFO per share guidance for the year was increased and reflects the capital allocation accretion. In addition, the updated guidance incorporates the operating assumptions on Page 30 of the supplemental, including a reduction in expected G&A expenses and lower straight-line rent from asset sales. The midpoint of guidance does not assume repayment in 2024 of the $3 million Stewart revenue reserve taken in the second quarter. It does assume that we'll continue to pay monthly rent of approximately $2 million as they did in June and July. Looking to the balance sheet, run rate leverage is 6.4x, including the expected debt repayment for remaining asset sales and JVs. The debt repayment is expected to pay off the $250 million term loan that expires next July, which will reduce 2025 debt maturities to less than $300 million. The combination of our operational and capital allocation momentum will drive an improved dividend payout ratio and lower leverage moving into 2025. I'll now turn it over to Rob for more details on our leasing progress.

Rob Hull, COO

Thanks, Kris. My comments today will be focused on multi-tenant occupancy gains and strong leasing momentum. We exceeded our bridge guidance in the first half of the year and expect further gains in the second half and into 2025. Multi-tenant occupancy improved sequentially by 37 basis points or 122,000 square feet. Coupled with the first quarter, net absorption for the year and our total multi-tenant portfolio was 183,000 square feet. At this level, we exceeded the top end of our bridge guidance for the first half of the year by over 30%. Our outperformance was driven by greater-than-expected new lease commencements and a move out rate that was over 300 basis points lower than historical levels. Over the last three quarters, we gained 112 basis points of occupancy in our multi-tenant portfolio. This puts us on track to deliver the 150 to 200 basis points of multi-tenant occupancy gains published last November in our five quarter bridge. It is also worth noting that the legacy HTA assets have gained 172 basis points of occupancy over the same period, highlighting our ability to drive absorption in that portfolio. Strong absorption led to total multi-tenant NOI growth of 3.9% for the second quarter, at the top end of our first half bridge guidance. Our leasing activity this year has been supported by favorable supply and demand fundamentals. Occupancy across the sector continues to climb and new MOB starts continue to trend lower. This quarter, absorption in the MOB sector reached 5.5 million square feet, the most on record since the data has been tracked. Health system top line revenue and our operating margins continue to improve. Providers are seeing solid outpatient volume and revenue trends. Longer-term, we expect demand to continue rising. Spending on health care services is expected to increase at 5.6% annually over the next decade. Over the same time period, the over 65 age group will grow at more than 9 times the rate for the remaining U.S. population. And those over 65 are the largest users of health care services, spending 4 times more than those under 45. The combination of limited new supply and rising demand creates a tailwind to support ongoing leasing momentum. New signed leases in the second quarter totaled approximately 432,000 square feet. Notably, this marks our fourth consecutive quarter above 400,000, an important part of the equation driving our projected gain of 100 to 150 basis points absorption this year. Our new lease pipeline reached 1.9 million square feet in the quarter, its highest level ever. This gives us visibility and positions us well to achieve projected absorption gains outlined in our bridge. Our team has executed well in the first half of 2024. And delivering a robust level of new leasing and outsized solution with current multi-tenant occupancy at 85.9%, we are early in the innings of a multi-year plan to reach 90% across our multi-tenant portfolio. This will drive continued absorption and outside NOI growth in 2025 and beyond. Now I'll turn it back to Todd for some final remarks.

Todd Meredith, CEO

Thanks, Rob. Now I'll just make a few more comments before we shift to the Q&A portion. As our announced JV and asset sale transactions are completed over the next quarter or so, we expect to have excess proceeds to redeploy. In the near term, our capital allocation priorities are first to fund our existing obligations such as the positive absorption capital I mentioned, which is our highest return on investment by far. Second, to repurchase stock accretively if the price trades at a discount, and third, to repay debt, keeping our leverage neutral or trending lower. So '24 is shaping up to be an important year for HR in terms of building momentum and executing on our capital allocation and operational objectives. We're increasing 2024 FFO guidance based on strong first half results. External tailwinds of limited MOB supply and robust outpatient demand are bolstering our outlook for the second half of '24 and 2025. We full dividend coverage is well within reach and poised to keep improving in 2025 and 2026. And Healthcare Realty's balance sheet is strengthening with leverage expected to trend lower. Cameron, operator, we're now ready to move to Q&A.

Operator, Operator

Thank you. We will now begin the question-and-answer session. The first question is from Juan Sanabria with BMO Capital Markets. You may proceed.

Robin, Analyst

Just on Stewart, what's the expectation, how much space they look to keep. Are they looking to lower any contractual rent? How does it compare to the market?

Todd Meredith, CEO

Sure, Robin. It's very early to really be speculating on where that may go. Obviously, we all are paying attention very closely to what may be happening on the hospital front, and that's clearly driving this process through the bankruptcy process. Still very early. And so we are not down to a point where we're engaging. I think the good news is that the outpatient space is needed, and it will kind of play out after the hospital pieces are sorted out. So we're really not speculating. The one thing I can say about rents is we've done an assessment. We don't view that there's any material difference in terms of where our rents are versus market. We feel very good about that. And obviously, any other speculation about space and what will be used or not, it’s just way too early to tell. We're very encouraged by what we're hearing generally speaking.

Robin, Analyst

And the $120 million real estate impairment in the quarter, was that related to Stewart or something else? Just curious.

Kris Douglas, CFO

No. It's related to the asset sales that are ongoing and expected to close here through the balance of the year.

Robin, Analyst

Okay. Thank you.

Operator, Operator

The next question is from the line of Austin Wurschmidt with KeyBanc Capital Markets. You may proceed.

Austin Wurschmidt, Analyst

Great. Thanks. Todd, I'm just curious how sustainable you think the 85% retention is over the next 12 to 18 months. Just trying to understand that, I guess, given that multi-tenant retention this quarter appeared to be lower. I also recall, I think you have some single tenant move-outs later this year, another 1 million square foot of expirations on the single tenant side next year. So trying to think about it a little bit holistically as well as the breakout between multi and single tenant over that time frame?

Todd Meredith, CEO

Sure, sure. Good question. Obviously, we're pleased with being around 85% now for a couple of quarters. Generally speaking, single tenant tends to sort of bring the average up a little bit. The mix isn't very high, as you know, in single tenant versus multi, but it brings it up maybe 1% or so year-to-date in this quarter. But I would say, generally speaking, we expect the multi-tenant to really be in that 80% to 85% range. Obviously, we hit some numbers that were in the mid to upper 70s last year as we were continuing to work through the integration of the portfolio, increasing our service levels across the whole portfolio. And we've really seen that come around and really turn out to really strong retention. Service levels are very strong. The team is fully in gear. And I think also on the leasing side, we're making very concerted efforts where we see tenants who may be thinking about leaving, working with them aggressively to see what we can do to retain them. So it's a joint effort across all of our teams. And I think it's really, really paying off. And we do think we can sustain this sort of 80% to 85%. Obviously, in the quarter can vary. But I think importantly, over the timeframe you talked about the rest of this year or next year, we'll be looking to produce 80% to 85% and really similar levels across multi and single generally higher in single, but in that same range and working on the backfill on both multi and single to not only backfill, but create positive absorption.

Austin Wurschmidt, Analyst

That's helpful. And then just maybe hitting on the guidance piece, implied kind of back half same-store growth in the multi-tenant portfolio. Think is at that lower end of that 4%, 4% to 5.5% range that you expect to achieve in the back half. Is that conservatism or you haven't really pulled forward the better performance in the first half? Or is there something else that's changed from a timing or back half growth perspective? That's all for me. Thanks.

Kris Douglas, CFO

Yes, I would say it's the former just conservatism being halfway through the year. We're feeling good about where things are progressing so far in terms of occupancy as well as on operating expenses and especially for the quarter. We were at the upper end of both of those ranges, but it's halfway through the year, try not to get too far ahead of ourselves.

Operator, Operator

The next question is from the line of Michael Griffin with Citi. You may proceed.

Michael Griffin, Analyst

Great. Thanks. I wanted to ask first on leasing. It looks like cash leasing spreads declined slightly quarter-over-quarter, including the kind of negative cash rent spread bucket. It looks like it went up to about 10% from 4% of the leases in this quarter. Should we interpret this as tenants pushing back more on rent increases? Or was there something maybe market or tenant specific that drove this delta?

Rob Hull, COO

Yes. Hey, Michael, this is Rob. You're correct; cash leasing spreads were 2.9% this quarter. As we've mentioned this year, our main focus is on increasing occupancy, and our results reflect that with a lower move-out rate and higher occupancy. This manifests in two ways: in areas where we can increase rents, we're doing that where the market conditions allow us to exceed the averages we've shared. Additionally, in price-sensitive markets, we are proactively negotiating deals to maintain occupancy and prevent costly downtime and extra tenant improvements from backfilling spaces. We're effectively managing the extremes while being assertive on the higher end. Concerning the lower end of that spread, we're simply being more aggressive.

Michael Griffin, Analyst

Got you. Appreciate the color there, Rob. And then Todd, I appreciate your comments kind of on the CapEx spend now for occupancy benefit in the future. But kind of as we think about the cadence of that, what is going to be the near-term impact to FAD as a result of this CapEx spend you're going to need to spend on new leasing? And then how much occupancy upside or I guess looking at your return do you get as a result of that CapEx invested?

Todd Meredith, CEO

Sure. I've noted that this is clearly our highest return on investment by far. A simple way to think about it is that our marginal gross revenue from absorbed space averages around $36 for the portfolio. When you divide that by the upper limit of about $60 for the total cost of a new lease, it's evident that we are looking at a great return, estimated at 50% to over 60% on the marginal capital. From our perspective, this is a significant success and something we intend to pursue, comparing it to external investment opportunities that yield much higher returns. We view this as revenue-enhancing capital. While we haven't quantified it explicitly, we're anticipating an investment of about $20 million to $25 million this year, which will likely be similar next year, based on our absorption expectations. You can consider this when evaluating our payout ratio as it could reduce it by roughly 6%. This component is crucial for how we assess our dividend coverage as we move toward 2025.

Michael Griffin, Analyst

Great, that's it for me. Thanks for the time.

Todd Meredith, CEO

Thanks, Mike.

Operator, Operator

Next question is from the line of Mike Mueller with JPMorgan. You may proceed.

Michael Mueller, Analyst

Yes, hi. I guess your comments about multi-tenant occupancy going above 90%. First, was that a lease or an occupied comment? And what sort of time frame are you expecting to get there by?

Todd Meredith, CEO

Yes. Mike, Rob talked about a multi-year plan of getting to 90%. And when we talk about it in multiple years, we're talking about occupancy. Obviously, that lease percentage versus occupied is a delta that we track and report and gives us a lot of optimism along with our leasing pipeline that we can push gains over multiple years, but certainly looking out over the second half of this year and into 2025. And so if you look at this year, we're saying 100 to 150 basis points of gain in the multi-tenant portfolio, that's probably a similar range we'll be thinking about in '25, but it's a little early to lay that down specifically. But certainly another strong year in terms of our expectations next year. So if you started thinking about that as an annual pace, that's a three-year sort of time frame, but making some real headway in '24 and '25 on that.

Michael Mueller, Analyst

Got it. Okay. That's helpful. And then second question, are you expecting more activity with the Nuveen JV?

Todd Meredith, CEO

We are underway working on that. So we talked about a, what, roughly $400 million set of transactions with Nuveen. So that work is underway. And so I guess depending on your question, it's in process, a couple of closings. So very much expense.

Michael Mueller, Analyst

I was thinking beyond that, I mean, should we think of that as kind of a growing program beyond the $400 million that you flagged already?

Todd Meredith, CEO

It's absolutely an option. As we embarked upon this process earlier this year to sort of ramp up our efforts they came to the table interested and that was great. So obviously, we have a strong relationship with them, work with them regularly on our existing properties in our JV together. So they've really come back multiple times and through that relationship. So it's always an option. It's not maybe to differentiate a little bit with KKR. It's not necessarily expressed in a way like KKR has said we want to commit a certain amount of existing capital, equity capital to grow it. So it's more opportunistic. It's maybe the way I would describe it versus KKR being more of a programmatic commitment that we'll look to grow.

Michael Mueller, Analyst

Got it. Okay, thank you.

Todd Meredith, CEO

Thanks, Mike.

Operator, Operator

The next question is from the line of Rich Anderson with Wedbush. You may proceed.

Richard Anderson, Analyst

Thank you. Good morning. You mentioned the revenue-enhancing capital expenditure program. If you hadn't pursued it, you would be at a 100% payout, which you hinted at. Can we focus on the relationship between that and the dividend coverage? How much longer do we need to wait for dividend coverage if you continue investing $20 million to $25 million with the strong returns from those incremental investments, rather than halting the program now, which you’re not considering, in order to achieve coverage?

Todd Meredith, CEO

Yes, maybe to think about the trajectory of those two approaches with and without the revenue-enhancing treatment there. We still think we can drive towards a covered dividend and even with that extra capital sort of towards the end of '25. But obviously, if we have outsized absorption capital, then maybe that ticks you over a little bit, but that's obviously a good problem to have. This is a ramping process and our occupancy and the flow-through. So clearly, the further out you go, the more beneficial you're starting to get all the NOI, EBITDA, FAD that comes from that coverage. So it really becomes less of a concern late in '25. But treating it as revenue-enhancing capital is sort of separate than maintenance CapEx, you get there basically going into '25. So that's the difference.

Richard Anderson, Analyst

Okay. Next question. You've got $1 billion of dispositions. And well, I guess the first part of the question is the buyback option at today's stock price, is that essentially off the table? Or does it still make sense to buy back stock at these levels?

Todd Meredith, CEO

Yes. Maybe to use the stop light analogy, there's red and green, but then there's sort of the yellow. And I would say that's where probably we are today where you're right, the accretion gets pretty minimal. And maybe a different way to express it is what discounts to NAV and I'm just kind of using market consensus for the NAV levels. Once you get into the 10%, single-digit, less than 10% discounts to NAV, yes, the accretion math starts to fade. And so that's sort of where we're trading right now, which is a good thing. It's been moving in the right direction. So we got in early. We bought nearly 30% discounts to NAV and then continued all the way down to about 10%. And as Kris said, sort of average 20%. So there's a little more that can be gained. And I think really, our view is we'll just be opportunistic. And if we see dislocations, we'll jump on it.

Richard Anderson, Analyst

Okay. So that leaves the question. You got this capital program, 20 million, 25 million share buyback on and off, we'll see. And then debt repurchase, your asset sales are creating a stream of impairments. And so that's one sort of ghost factor. And then the other is on the debt repurchases. Will there be prepayment penalties associated with that, since that maybe will be weighted more in the deployment math. So can you comment on both potential for more impairments and the potential for prepayment penalties on the debt? Thanks.

Kris Douglas, CFO

Yes, Rich, this is Kris. So on the impairments, yes, we have had to take some of those, but really think about it, a lot of those have been assets that were valued at the merger. And so at that point, cap rates were in the kind of low to mid-5s where they were put on. And so now we're saying, we're selling them in the mid-6s. And so that's really a balance sheet impact that doesn't change at all what's going through on the income statement and what happens on your accretion. But that's the reason that you have the impairments that are going on. And so we'll continue to see some of that as we continue with the asset sales. In terms of the debt repayment, we still have capacity right now in terms of bank lines. I mentioned our delayed draw term loan, $250 million. We paid down $100 million in the second quarter. We have $250 million left that was set to expire July of '25. So that will be a priority of ours to pay off and there's no prepayment penalty associated with that. And the overall cost on that is around 6.4%. So it's not a significant negative drag to be paying that type of debt down. And then we certainly have a bit of a line balance that we'll address that as well. So generally, from what we see right now, we're not having to get into prepayment penalties, but if we increased it, then we certainly would take that into consideration as we're considering our options.

Richard Anderson, Analyst

So there's a good chance then you could be sitting on more cash than anticipated by the end of this year because of all these moving parts. Is that a fair statement?

Todd Meredith, CEO

No, Rich, I think if you look back at what Kris described in his prepared remarks, the $1 billion, the way we think about it is there's about $200 million if you look at our capital obligations that comes out first. That's development, redevelopment funding, it's this revenue-enhancing capital that I was talking about, first-gen acquisition capital. So you pull that $200 million out, you're at $800 million. And then if you think of 50-50 leverage neutral, as a rough guide, that's $400 million for debt repayment, $400 million for stock buyback. Obviously, there's some flex in there. We've used up about $300 million for stock buyback. So it kind of leaves us with about $500 million. And Kris, just if you look at our debt, we have variable rate debt that we can pay off, it's about $500 million between the line and that term loan Kris mentioned. So I really don't see a scenario where we're sitting on excess cash there.

Richard Anderson, Analyst

Okay, thanks very much.

Todd Meredith, CEO

Rich, we'd have to increase our proceeds beyond the $1 billion, let's put it that way.

Operator, Operator

Okay, thank you. There are no additional questions waiting at this time. I would like to pass the conference over to the management team for any closing remarks.

Todd Meredith, CEO

Thanks, Cameron. We appreciate it. Thank you, everybody, for joining us today and we will be around and available for follow-up and look forward to seeing many of you soon. Take care.

Operator, Operator

That concludes the Healthcare Realty second quarter earnings conference call. Thank you for your participation, and enjoy the rest of your day.