Healthcare Realty Trust Incorporated (NYSE:HR) Q4 2023 Earnings Call Transcript
Healthcare Realty Trust Incorporated (NYSE:HR) Q4 2023 Earnings Call Transcript February 16, 2024
Healthcare Realty Trust Incorporated isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good morning or good afternoon, and welcome to the Healthcare Realty Trust Fourth Quarter Earnings Conference Call. My name is Adam, and I will be your operator for today. [Operator Instructions]. I will now hand the floor to Ron Hubbard, Vice President of Investor Relations, to begin. Sir Ron, please go ahead when you are ready.
Ronald Hubbard: Thank you for joining us today for Healthcare Realty's Fourth Quarter 2023 Earnings Conference Call. Joining me on the call today are Todd Meredith; Kris Douglas; and Rob Hull. A reminder that except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risks and uncertainties. These risks are more specifically discussed in the company's Form 10-K filed with the SEC for the year ended December 31, 2023. These forward-looking statements represent the company's judgment as of the date of this call. The company disclaims any obligation to update this forward-looking material. The matters discussed in this call may also contain certain non-GAAP financial measures such as funds from operations, or FFO, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, or FAD, net operating income, NOI, EBITDA and adjusted EBITDA.
A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release for the quarter ended December 31, 2023. 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: Thank you, Ron, and thank you, everyone, for joining us this morning. Healthcare Realty generated solid quarterly results meeting or exceeding expectations on several key metrics. Normalized FFO of $0.39 per share for the fourth quarter was steady and in line with our expectations. Same-store growth for the quarter and year was in the upper half of our guidance range. You will recall, we published a bridge last quarter, outlining our expectations for multi-tenant occupancy and NOI growth, starting with the fourth quarter. We are pleased to report over 50 basis points of positive absorption at the very top end of our expected range for the multi-tenant properties and NOI growth accelerated above the high end of our range to 3.3% for all multi-tenant properties, not just same store.
These strong fourth quarter results were achieved through the focus and incredible efforts of our leasing and operations teams. Looking forward, we see a couple of areas where we can keep improving. First, retention. We made incremental progress on tenant retention achieving just over 78% in the fourth quarter compared to 76% in the third quarter. What's significant is that retention at the legacy HTA properties was in line with the HR portfolio. And we see the ability to push retention higher to more than 80%. A second opportunity for improvement is operating expenses. The fourth quarter came in better than expected at just over 4% growth. That's in part due to lower property taxes. We see more opportunity to reduce expense growth to the 3% level in 2024.
Together, higher retention and lower expenses will help us reach the upper end of our '24 goals. What I'm most excited about is our new leasing momentum. Our leasing team signed new leases totaling 425,000 square feet in the fourth quarter. This marks 3 consecutive quarters averaging over 400,000 square feet. The strong pace of new signed leases is what fuels the occupancy gains in our bridge and forecast for 2024. As we look more broadly at what will drive our '24 growth, we are seeing an uptick in demand from both health systems and independent physician groups. On top of this, supply has steadily tightened, which provides a favorable backdrop for leasing momentum and occupancy gains. What it comes down to is more tenants chasing fewer MOB.
To illustrate this point, look at replacement rents today versus 2019. Construction costs have escalated at an annual average of more than 7% over the last 5 years. Couple this with much higher financing costs and you have a recipe for much higher replacement rents. Back in 2019, typical MOB development costs were about $350 a square foot in a place like Dallas. Required yields were in the low 6s, putting net rents around $22 per square foot. Five years later, equivalent MOB development costs are approaching $500 a square foot, and rent yields are now around 8%. That means replacement rents are approaching $40. So replacement rents have increased more than 80% in 5 years or more than 12% annually. This limits new supply and sets us up to improve occupancy and rates in existing buildings.
At Healthcare Realty, we're laser-focused on maximizing occupancy gains in '24 with rate acceleration to follow. Now I'll turn it over to Kris for an overview of our financial and operational results. Kris?
James Douglas: Thanks, Todd. It was a solid fourth quarter with normalized FFO per share of $0.39. FFO dollars were $2.7 million higher than the third quarter. The sequential improvement was the result of a $3.1 million reduction in interest expense from asset sales that were used to repay the line. This was offset by a $4.2 million reduction in NOI from dispositions. Additionally, operating expenses net of recoveries were down $3.7 million sequentially. The reduction in operating expenses was primarily from the reversal of third quarter seasonal utilities as well as lower property taxes. The lower taxes was the result of successful appeals and lower rates, especially in Texas. Approximately $2.4 million of the property tax benefit was related to prior periods and will not repeat in future quarters.
The lower property taxes contributed to improved operating expenses. Operating expense growth was 4.1% for the quarter which was down from 4.8% in the third quarter and 5.3% in the second quarter. Same-store revenue fundamentals also improved. Year-over-year quarterly same-store NOI growth was 2.7%, up 40 basis points from last quarter. Revenue growth of 3.2% was driven by a 3% increase in revenue per occupied square foot and a 20-basis point improvement in average occupancy. Cash leasing spreads in the quarter averaged 3.3%. We ended the year with total portfolio in-place rent escalators of 2.81%. This is up 15 basis points since the first quarter of 2023. The improvement was driven 2 ways: first, from higher escalators for new and renewal leases, which averaged 2.95%.
This was well above expiring leases, especially for legacy HTA escalators that were averaging 2.5%. Second was addition by subtraction. The average escalator of properties sold during 2023 was 1.9%, significantly below the rest of the portfolio. Sequential same-store occupancy increased 65,000 square feet or 20 basis points to 89.2%. Even more impressive, total portfolio multi-tenant occupancy increased 175,000 square feet sequentially. The strong leasing volumes contributed to an increase in maintenance CapEx. Total maintenance CapEx for the year was 18% of NOI or $152 million. This was in the middle of our guidance range for the year. The FAD payout ratio was over 100% for the year. With the anticipated strong absorption in 2024, the payout ratio is likely to remain elevated as we invest in tenant build-outs.
We are comfortable the payout ratio will come back down as we fully realize the NOI from the positive absorption. Net debt to adjusted EBITDA at December 31 was 6.4x, within our target range. Net debt was lower as the line of credit was fully repaid at year-end from $338 million of asset sales in the quarter. Looking ahead, normalized FFO guidance is $1.52 to $1.58 per share for 2024 and $0.38 to $0.39 for the first quarter. Guidance and the major assumptions are outlined on Page 6 of the supplemental we released this morning. To provide context for guidance, we walk forward the major drivers from an annualized fourth quarter FFO run rate of $1.52 per share. The run rate adjusted for out-of-period items such as the property tax appeals. The major growth driver in 2024 will be internal operations.
Multi-tenant absorption is projected to be 100 to 150 basis points and generate $21 million to $29 million of growth in cash NOI. Single-tenant cash NOI growth is projected to be plus or minus 1%, which is below in-place escalators of 2.5% because of 2 general office expirations. A government services tenant vacated the end of the release in January. The building sits at the front door of CommonSpirit St. Anthony Hospital in Denver. When we purchased this property in 2018, the plan was to raze the building and redevelop the parcel. We are working with the hospital on the long-term redevelopment plans and expect to demo the building later this year. The lease for the other property will expire at the end of January. We are marketing the building with a goal of selling the property before year-end.
We have not projected any new rent or sale proceeds from either property in 2024 so any progress on these fronts would be upside. G&A expenses are projected to increase $5.8 million at the midpoint. The increase is primarily related to returning to run rate incentive compensation levels as materially lower performance-based compensation in 2023 is creating a tough comp. The other major headwind is a $200 million interest rate swap with a 1.21% fixed rate that expired in January. In preparation for the expiration, we executed new interest rate swaps during the fourth quarter at an average rate of 4.71%. The new swaps will cost $7 million more annually. There are no acquisitions assumed in guidance. We are projecting $150 million to $250 million of dispositions to match fund our capital needs during the year.
The multi-tenant absorption in our guidance is consistent with the occupancy and NOI bridge we introduced last quarter. As Rob will discuss in more detail, an updated occupancy bridge is included on Page 21 of our investor presentation. It shows that we expect sustained positive momentum on occupancy absorption through 2024. This will help drive accelerating NOI growth and generate a strong FFO exit velocity going into 2025. I will now turn it over to Rob for more detail on our leasing progress.
Robert Hull: Thanks, Kris. Healthcare Realty posted another strong quarter of leasing activity. New signed leases totaled 425,000 square feet that were 13,000 square feet greater than our fourth quarter projection. For the year, our team signed 449 new lease deals for a total of almost 1.5 million square feet. Approximately 60% of these came from the legacy HTA portfolio, which represents slightly over half of our multi-tenant portfolio. In addition, 226 renewals totaling 1.2 million square feet were signed during the quarter, bringing total renewals for the year to 817 that totaled 4.2 million square feet. Our leasing team under the leadership of Amy Poley, senior VP of Leasing, did an extraordinary job of driving momentum in 2023.
I want to commend Amy and her team for their hard work and tenacity. Strong leasing throughout the year culminated in 518,000 square feet of multi-tenant lease commencements in the fourth quarter. Combined with lower sequential move-outs, multi-tenant occupancy jumped 53 basis points. This equates to 175,000 square feet of net absorption. This level is at the upper end of the range we provided in the multi-tenant occupancy and NOI bridge published in November of last year. On the disposition front, Healthcare Realty sold 19 properties for $656 million at an average cap rate of 6.6% during the year. These were largely non-core assets with 34% non-MOB and 63% single tenant. We also fully exited smaller markets like Sebring, Florida, and Evansville, Indiana.
What I like most is we improved the growth profile of the portfolio by selling properties with annual escalators averaging 1.9% versus 2.8% for the broader portfolio. Our MOB operating fundamentals remain healthy. The transaction market continues to be governed by interest rate volatility. Until we see stable rates over a longer period of time, we expect lower transaction volumes and smaller deal sizes. For now, we see MOBs trading in a range of 6% to 7% with the higher quality properties in the low to mid-6s. Turning to expectations for 2024. Healthcare Realty's outlook for leasing is strong. Our new lease pipeline remains about -- remains robust at 1.5 million square feet and provides visibility into several quarters of leasing volume. Across the country, new MOB development starts have been trending down over the past 12 months.
In the fourth quarter, they were down by over 40% year-over-year. This trend has been driven by tightening credit markets and, as Todd mentioned, a healthy increase in construction costs over the past 5 years. At the same time, occupancy across MOBs has continued to climb. Additionally, we are seeing increased health system demand for space as volumes and financial measures improve. Recently, a couple of for-profit hospital operators reported a 3.6% year-over-year increase in outpatient surgical cases. And hospital operating margins steadily improved throughout 2023. Positive supply-demand fundamentals and improving hospital performance will serve as tailwinds for our 2024 absorption goals. We updated our multi-tenant occupancy and NOI bridge in our recently published investor presentation.
The primary change is to the starting occupancy, reflecting the sale of some highly occupied properties during the fourth quarter and the completion of the development. It is also worth noting that we expect absorption during the second half of 2024 to be stronger than in the first. These are shaped by 2 seasonal patterns. First, we have about 2.7 million square feet of expirations in the first half of the year versus 2.1 million in the second. Even with the consistent renewal rate, we expect more move-outs in the first half of the year versus the second. Second, new lease commencements have historically been lower in the first half of the year versus the second. As a result, we expect net absorption in the second half of the year to be about 200,000 square feet greater than the first.
We are reiterating our expectation for 100 to 150 basis points of occupancy gain in 2024 on top of the 53 basis points of absorption this quarter. Our leasing team is off to a great start this year. They are energized by growing demand for health care services and a tightening supply/demand backdrop. Looking ahead, I'm confident in our ability to drive absorption that translates into multi-tenant NOI growth of 4.5% to 5.5% in the second half of 2024. Now, I'll turn it back to Todd for some final comments.
Todd Meredith: Thank you, Rob. Before we begin our Q&A, I'll touch on capital allocation and our outlook for '24. We exceeded our own disposition expectations in 2023. We sold $656 million at a cap rate of 6.6% for the year, with over half occurring in the fourth quarter. And what's significant is these sales improve the quality and growth profile of our portfolio. Looking ahead, we're shifting to a more routine annual pace of portfolio optimization. In '24, we expect dispositions of $150 million to $250 million, which will fund capital obligations, including redevelopment and developments. Beyond this, we're pursuing accretive capital allocation opportunistically. We continue to work towards strategic JV partnerships that diversify our capital sources and extend our ability to meet long-term provider demand.
In our initial '24 guidance, we've conservatively assumed no JV transactions. Finally, our outlook for '24. We've updated our occupancy bridge -- our occupancy and NOI bridge. Building on the strong absorption in the fourth quarter, we expect healthy occupancy gains and NOI growth in '24, consistent with what we communicated last quarter. For FFO guidance, robust multi-tenant absorption and NOI growth is the primary driver that moves us into the upper half of our guidance range. For Healthcare Realty, sustained operational growth in '24 will set the table for attractive FFO and FAD growth in '25. Operator, we're now ready to begin the Q&A period.
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