Q1 2022 Physicians Realty Trust Earnings Call
Patients here.
Historically growth in medical office rental rates have been generally limited to 2% to 3% both in annual lease rate increases and renewal spreads.
Any growth in excess of this range is typically required excessive incentive packages that have served to increase headline rents at the expense of net effective rent actually reducing total cash flow.
Have and continue to resist the temptation to embrace short term measures that improve quarterly statistics at the expense of long term growth and firmly believe that this is the right approach that best benefits our shareholders.
That's why I'm excited to share that we see for the first time in my 20 years of experience in medical office, the opportunity to organically grow lease level cash flows by more than 3%.
Amy Hall, our senior Vice President of leasing and physician strategy, we'll share more information a few minutes about our experience year to date and our expectations moving forward.
<unk> pipeline to finance development is deeper than ever our strategy for development has been to align our interest with third party developers and health systems.
Nancy projects directly at a cost that allows for initial rents that are in line with market, while providing our shareholders with accretive returns.
These accretive returns come initially in the form of the development yield but later in the form of an attractive purchase options. It is a deliberate decision that we don't self performed development as you don't want to compete with the many great developers that we partner with the serve our health system and physician clients.
This also benefits our shareholders as we avoid the significant G&A cost of a development team that would be both cyclical and redundant with the skills of our clients.
On our last call, we forecast that 250 to 500 million of new investments in 2022 inclusive of stabilized acquisitions and new development.
As of today, we estimate we will have the opportunity to finance projects that will cost approximately $160 million to build and we will have value in excess of $200 million once online in 2023 and 2020 for the <unk>.
Pipeline is highlighted by pre leased health system anchored medical office facilities and ambulatory surgical suites in fast growing top 20 msas.
While construction costs are inflating our projects are financed on a yield on cost basis that is higher than acquisition cap rates with.
With a GMP construction contract in place.
Development momentum remains strong in today's rate environment as providers understand that they need more outpatient surgical and diagnostic facilities outside of the four walls of the inpatient hospital.
This is appropriate clinically as it moves care to the lowest cost setting while preserving precious hospital resources for the treatment of infectious disease and provision of high acuity services.
Outside of development, our investment philosophy remains focused on best in class facilities, where we can add value through superior customer service that drives retention and cash flow growth.
Cap rates on stabilized properties have compressed each year since 2013, but its our view that the compression is most seen in older class C properties Accordingly, our investments beginning with the acquisition of the Chr portfolio in 2016 have focused on higher quality facilities that may be more expensive on a nominal basis, but are expected to provide the best.
<unk> risk adjusted IRR over the long term.
Each of our investments are made based on the expectation that the property will benefit not from further cap rate compression, but from its long term strategic value to the health care providers.
While there is a high volume of class B and C assets available to acquire in the market. We don't believe that they carry in that field relative to the class a assets.
We're targeting to offset the risk and owner takes on in today's environment.
Instead, we will remain disciplined and selective pursuing investments, where we can match our long term objectives with those of the health care providers occupying those assets.
This focus on high quality assets includes the environmental impact of our investments we continue to be excited about the results. We've achieved on our environmental three year goals established <unk> 19 that matured in 2021.
That is just the start and we will report those results formally and transparently and our third annual ESG report to be released in June 2022.
As we will share data and we are increasing our commitment in all areas to reduce greenhouse emissions that the environmental impact of our billings for the improvement of the communities, we serve and remain on target to achieve our goal of reducing greenhouse gas emissions by 20 by 40% in 2013.
We also believe that evidence shows that investments will generate stronger retention higher rental rates lower occupancy cost, while producing better cash flow and long term value for our shareholders.
I'm proud to share that physicians Realty Trust is honored to once again be recognized by the Milwaukee Journal Sentinel as a top workplace for the fifth consecutive year Todd.
<unk> top workplaces are determined through an annual team member survey and collecting data on company leadership compensation and work environment.
Congratulations to the entire Doc team on building and maintaining our unique company culture that continues to be recognized among the best in both Milwaukee and our industry.
Study after study shows that companies with a focus on culture deliver superior total shareholder return over the long term.
We will not sacrifice our commitment to culture for short term financial benefit.
We're also proud to share that our senior vice president of physician and leasing strategy and U haul has been selected as a 2022 Globe Street woman of influence.
This award shines a light on individuals that have personally impacted the market and significantly driven the industry to new heights via their outstanding success across commercial real estate.
Thank you Amy.
We completed our annual shareholder meeting yesterday, and I'm proud to report, we had 95% or greater approval for each of our trustees and for our executive compensation plan.
We work for our shareholders and while others are distracted and trying to restore the trust of their shareholders.
Have the trust and are able to focus on working with our outstanding physician clients health system partners and developers delivering long term returns for our shareholders.
We appreciate our loyal shareholders recognize us for our discipline and strategy for long term growth and we welcome new investors as they too recognize the strength and stability of our trusted platform.
I'll now ask Jeff Theiler to share our financial results Mark <unk> will then share some of our operating results and Amy Hall, who will report on the current leasing environment, yes.
Thank you John in the first quarter of 2022, the company generated normalized funds from operations of $63 4 million or.
<unk> 27 per share our normalized funds available for distribution was $61 5 million, an increase of 13% over the comparable quarter of last year and our fad per share was 26.
Portfolio performance was steady this quarter generating same store NOI growth of 2%.
Importantly, the landmark portfolio has been successfully integrated and is performing at our underwritten expectations.
Across the portfolio, we are seeing continued strength in the operations of our tenants both in the reported financials and insurance claim volumes that we monitor on a near real time basis.
Based on the carefully curated portfolio, we built over the past nine years. We believe we are well positioned for long term success no matter what happens in the macro environment.
Speaking of the macro environment as everyone knows we are already seeing data that reflects the highest inflation in 40 years. Our portfolio is built to withstand the destructive force we've always concentrated on providing predictable and secured cash flow to our investors by embedding expense recovery provisions with a 98% of our leases to pass on those inflation.
Dairy costs. The tenant we also maintain the highest occupancy in this sector, which minimizes the cost leakage of those expenses to vacancy.
Combined these attributes result in a landlord expense expense protection ratio of 93%, which is unparalleled and provide certainty of income for our shareholders.
Moving forward as market participants consider the negative GDP print of minus one 4% for the first quarter. There has been increasing concern about the durability of the economic recovery.
We don't profess to know exactly what the future holds for the U S economy, but we are certainly comforted by what we do now 64% of our rental income is derived from investment grade quality entities are there direct subsidiaries as we saw over the course of Covid when we collected over 99% of our rent and put just one single tenant on a short term dip.
We believe that our rental income is safe no matter, what happens exceptional tenants leading to exceptional stability.
That same theme rings true on the capital side, we were able to raise $500 million in October of last year at a rate of 262, 5% using $250 million of that to pay off our term loan that was due to mature in 2023, eliminating our one significant near term funding risk.
Our balance sheet overall is in great shape, our consolidated leverage at 565 times debt to EBITDA will be substantially below our single MLP peer assuming their merger passes the shareholder votes.
In summary, our company remains on solid financial footing and is poised to perform well in any environment with that I'll turn it over to Mark.
Thanks, Jeff.
I am once again pleased to highlight the value of our asset management leasing and capital projects teams, who delivered another solid and consistent quarters.
Our relationship driven platform and culture cannot be easily replicated in today's labor market and our investors significantly benefit from the concentrations and knowledge that we have developed in our top markets across the country.
From a performance perspective, our mob same store NOI growth in the first quarter was 2.0%.
The NOI growth was driven primarily by a year over year to 6% increase in base rental revenue and operating expense recoveries as our net lease structure served to protect our investors in this inflationary environment.
Our focus on landlord expense protection is best shown in our sequential same store results were operating expense recoveries grew nine 8% and offset the eight 5% increase in operating expenses observed relative to the prior quarter.
Sequentially same store portfolio occupancy remained flat at 95%. However, we are optimistic that the occupancy in the same store pool will grow in the second half of the year. As we currently have 15 leases totaling 49000 square feet that are under construction have not commenced and are not yet <unk>.
<unk> and our occupancy statistics.
Had those leases have been in place and paying rent throughout the quarter annual same store growth would have been upwards of two 4%.
Turning to Capex, our capital projects team efficiently completed Fad Capex investments of $5 7 million, representing six 2% of cash NOI.
Embedded within all capital investments made by Doc is a strong commitment to the materials and practices that enhance the patient experience as well as our ESG green the green philosophy.
These efforts continue to be independently recognized with Doc proudly, earning 10, new property level energy star certificates in 2021 as well as 10, new certified sustainable property designations from the Institute of real estate management.
Over the last three years <unk> has earned a total of 28 certified sustainable property designations and reduced our energy usage and greenhouse gas emissions by over 10% continuing our record of recognition for leading sustainability initiatives.
We look forward to continuing the sustainability conversation in June following the release of our third annual ESG report.
The narrative on medical office has long been focused on the predictability and safety of the underlying cash flows and we firmly believe that the Doc portfolio is positioned to deliver outsized internal growth in the quarters and years to come through the efforts of our talented and determined operating teams joining.
Joining us today to share more about the leasing trends, we're seeing in today's medical office market is our senior Vice president of leasing and physician strategy Amy Hall, Amy Thanks.
Thanks, Mark it's a pleasure to join the team on the call today.
Prior to joining <unk> in 2016, our can of leasing industry for over 10 years at CBRE and Cushman Wakefield service CACI, which is now kind of spirit as one of my main client.
That experience helps me and dock execute a balanced leasing strategy maximizing value for our shareholders and remaining or what are the priorities of our health system tenant to achieve the best long term outcomes for both parties.
Before we dive into seven quarterly result, it is important to remember that perspective leasing conversations are.
Often begin as early as six to 12 months before commencement.
While the first quarter leasing results were reasonably good.
Our realized without the full benefit of recent inflation that has increased cost across the board, including the cost of new MLB construction by more than 20% in the last year that we will.
It really start to see the impacts of those changes with higher releasing spreads in Q2 and beyond.
The first quarter, our leasing team completed 209000 square feet of lease renewals in the consolidated portfolio at an aggregate re leasing spread of two 1%.
Consistent with historical trends at 2% to 3%.
Excluding the impact of a 5000 square foot tenant that we strategically retained at a lower rate in order to preserve the cohesive ecosystem multi.
Multi tenant property re leasing spreads for the quarter were above 3%.
Also kept pis well at $1 28 per square foot per year.
Well below industry averages as they continue to focus on net effective rent as the most important measure of total leasing performance.
Tenant retention for the quarter was 76%.
Mostly in line with our 80% to 85% target with portfolio absorption remaining effectively flat.
Our strong overall absorption and occupancy rates continue to provide confidence that we can selectively vacate certain sweet and find higher rental potential with different tenants.
New lease pis totaled $2 at 1% per foot per year as tenants opted to contribute more of their own capital towards tenant finish to reduce the growth rate in this landlord friendly environment.
Demand for medical office remains robust both off campus Andi.
As health systems, and physicians work to position, our outpatient real estate footprint to best serve their patients.
This demand backstopped with inflation that increases the value of our existing medical office assets gives us confidence that leasing economics will continue to accelerate throughout the remainder of 2022 and in the years to come.
We expect leasing spreads for the second quarter it could be in the mid to potentially even high single digits.
Awesome negotiating leases that went visibility to third and fourth quarters, where we expect renewal spreads to be in the mid single digit alongside these higher than expected spreads. We're finding success in increasing tenant rent escalators to be better aligned with today's inflationary environment.
For example, current market conditions allowed our team to increase the annual rent escalators for a major health system lease from 2% to 5% in fact at the fifth.
Three renewals completed during the first quarter 11 hadn't left an escalator that was greater than prior in place measures.
Escalators on new leases averaged two 7% in the quarter meaningfully ahead of our two 4% portfolio average and we expect to continue to find success on this front moving forward.
This is especially true in our urban markets like Atlanta, and Phoenix market escalators are now approaching 4%.
These trends indicate a structural shift in the MLP market and barring unforeseen circumstances, we expect them to continue in the years ahead.
I'll leave our portfolio is well below market rates overall and see our upcoming lease role in this environment as an opportunity rather than a risk but.
Put simply docks medical office portfolio is poised to capture the benefits of this inflationary environment with that I will hand, it back over to J T.
Thank you Amy.
Doug we're now happy to take questions.
Yeah.
Thank you ladies and gentlemen at this time, we will be conducting a question and answer session.
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Our first question comes from the line of Nick Joseph with Citi. Please proceed with your question.
Hey, This is Michael Griffin on for Nick I wanted to touch on external growth. The first curious what you think of the expectation for the cadence of investments to trend throughout the remainder of the year relative to initial guidance.
Yes, I think we're again, we're off to a little bit of a slow start again most of that's more attributable to kind of the volatility.
The capital markets interest rates in particular versus kind of opportunities that we see in our investment pipeline. So I think we're still on track for the year to do $2 $50 million to $500 million total that does include the development financing, which of course is kind of is.
We will be more back ended because of those projects just get started with this summer and youre spending as the construction process evolves.
But again I think I think there's plenty of good opportunities for us in the acquisition market as well, but it will be limited this year and more in the second half than the first half just due to the capital markets in particular.
Right.
<unk> you touched on cap rates relative to rising interest rates or prepared remarks.
I'm curious you know obviously with your expectations that interest rates are going to continue to increase for the near foreseeable future do you see an anticipated upward pressure in cap rates, maybe in the near to medium term.
I mean, you would expect it but we haven't seen it and.
I think that comes from just the flood of capital chasing the medical office.
There's a lot of class B and class C assets out in the market right now and that are trading in the low fives.
And those rates haven't really changed other than compressed since last year. So we will see how it goes and that's part of the reason why we're being patient and looking more to invest.
Investments if at all in the second half of the year, but we anticipate making those investments.
Great. That's it for me thanks for the time.
Thanks.
Our next question comes from the line of <unk> <unk> with Credit Suisse. Please proceed with your question.
Hi, Yes, good morning, everyone.
So in the latter part of 2021 with the things to our numbers again kind of.
Kind of more at the higher end of that 2% to 3% range had done a really good job with kind of operating expense management. This quarter. It looks like opex kind of ticked up quite a bit wondering if you could talk a little bit about that in.
The negative impact it had on your same store NOI.
Number.
Hi, Yes. This is mark on the operating expense side for the same store.
The.
The fourth quarter.
And first quarter are both a little bit higher.
Then what we typically see in our operating expenses.
This this quarter they are up about 4%, that's primarily driven by utilities and janitorial and <unk> and then sequentially utility rates have been have been increasing a little bit.
And then in the first part of this year, we also reset our annual real estate tax and insurance accruals. So those are a bit higher for the year, but the beauty and the strength of the Doc portfolio is that.
95% leased and primarily all triple net leased so we talked about our landlord expense protection.
And.
Those costs are passing back to the tenants.
So.
We're working hard as an asset management team to operate all of the buildings efficiently and cost effectively and utilizing our scale, especially in markets, where we exited concentration to manage those operating expenses.
And we think that through some of the Capex investments, we're making will.
We will be able to lower some of those utility costs in the back half of the year.
But again, we're optimistic about same store in the back half of the year as a result of.
Some of the leasing efforts and I think that the.
In the back half of the year, we'll be back up above our annual average rent escalator from some of the occupancy that's under construction that will be coming online.
That's helpful. And then also if I may ask one more question on the retention side again, the cognate has historically been 80% to 85.
Very close to it this quarter, but you guys are doing like 79, or so last quarter was like 76.
Kind of curious what again, what's happening on that end as well because the last few quarters.
You have had a negative kind of net absorption in the portfolio both in <unk>.
Yes, Thomas J T.
If you have four leases to renew and you renewed three of them that 75% right. So it's really more a function of that in the 80% both over the course of time, it's 80% to 85% quarter by quarter just depends upon how many leases you have what the square footage.
There is no downward or negative trend. There is just a function of our highly leased occupancy.
Okay. That's helpful. Thank you.
Our next question comes from the line of Austin more Schmidt with Keybanc. Please proceed with your question.
Great. Thanks, and good morning, everyone.
Given the comments you made on cap rates and thinking that you would expect upward pressure, but haven't seen it and where the stocks trading today I mean, the dispositions become more attractive funding source.
To fund sort of the investment activity for the year.
Yes, Allison and welcome to the team.
That's something where it's a great. It's a sellers' market, it's a great.
For dispositions, we don't have a lot that we really are interested in selling but we expect some opportunistic dispositions this year kind of capturing these.
Now these strong cap rates.
Per asset so I think youll see some dispositions during the year, but it won't be a huge number and we really like our portfolio overall.
Got it and then I'm just curious since you've closed the landmark portfolio. I think you had some new relationships that came from that have you seen any pickup in the investment pipeline around those.
New tenant relationships.
Yes, it's a little early for specific contracts or leasing upped I mean, we have.
We've got a great start on the leasing.
As well, but.
<unk> is it a.
Function with one of those helped us in the other day talking about their own investments in the building we bought plus.
The opportunity for expansion of the <unk>.
Additional twin buildings in that portfolio, so we really anticipate overtime.
A lot of great add on opportunities with those health systems.
Great. Thanks for the time.
Good luck.
Our next question comes from the line of Richard Hill with Morgan Stanley . Please proceed with your question.
Hey, guys. Good morning. This is Adam Kramer on for Richard.
Once basketball a bit more detail about kind of the acquisitions.
I recognize you are kind of maintaining this $250 million to $500 million kind of total investment activity Guide wondering if you could kind of give a split between acquisitions or external growth through acquisitions versus kind of the investments that you guys have talked about and then any kind of further.
I guess kind of commentary on the only investments that would be helpful as well.
So I think it's hard to predict and accurate split today, but probably 50 50 with <unk>.
A reasonable assumption between development starts and acquisitions I think we'll clearly get to 50% on the development pipeline as hard as we have that number and probably have some more opportunities there.
We might close in the third and fourth quarter, so probably a little bit of a lean toward the development to get to the higher end of that range.
But we've already completed subsequent to quarter end $27 million acquisition, which is adjacent to one of our other medical office building is very synergistic.
And that new Albany market.
With a great health system.
Frankly, a building that markdown and I've been chasing for 10 years again, it's adjacent to a building took us eight years to acquire.
We are persistent and.
And consistent so.
And I think I think the acquisition environment is fine I think there are some good opportunities out there, we're just being very careful and selective with the capital.
Capital market.
Yes, no that all makes sense I guess.
Been touched on a few times already so I apologize I'm kind of beating a dead horse, but also just wanted to kind of ask about.
Kind of whether I guess kind of a guide is.
It kind of implies a step up in <unk>.
Acquisitions.
Kind of the latter part of the year Ryan when cap rates may have kind of widened already Ryan you kind of mentioned already that cap rates may not have moved yet.
And so I'm wondering if kind of the big guys. Just kind of allows you to maybe capture greater acquisition volumes later in the year when when cap rates, we will have.
<unk>.
Widened.
Yes, I think I think your point is exactly what we're thinking which is those those assets that again almost all of our business is off market and so it's really a kind of ebb and flow in the negotiation trying to match funding with our cost with our capital and our cost of capital with the with the acquisition cap rate. So.
Certainly there can be more opportunities later in the year, particularly at cap rates due to.
To ease back a little bit and then.
Investment activity might accelerate.
That's really helpful guys. Thanks again.
We'll shout later on I appreciate it thank you.
Our next question comes from the line of Juan Sanabria with BMO capital markets. Please proceed with your question.
Hi, this is malaria on for one.
<unk>.
About funding how should we think about your acquisition pipeline and.
We shouldnt expect.
A large uptick in dispositions.
Yes. This is Jeff I'll kind of cover that so certainly as we as we think about funding and J&J mentioned it earlier.
There could be some opportunistic dispositions.
Yes.
There's been a lot of interest in various buildings in our portfolio. So we evaluate those of course.
Putting that aside when we evaluate these acquisitions, we're always making sure that from a cost of capital standpoint, it's advantageous to our shareholders to acquire them. So we look at what our cost of long term debt is and what our cost of equity is and make the determination based on that.
I think thats, a big part of the reason when we talk about the split of acquisitions.
A lot of that split is.
More of that split.
This year is dedicated towards developments.
Loan funding that kind of thing.
Okay Gotcha.
And one more question so recognizing that you raise shares via the ATM, what's your view of selling assets.
Buy back stock in a leverage neutral manner.
Implied cap rate of five eight which is what we have.
Yes, it depends so certainly.
To the extent we have assets that we don't think are good long term holds.
That is something we've done right and we did that back in 2018, when we when we did our portfolio and sold assets.
Took down leverage.
Mathematically it isn't really that effective when our share price is where it is to sell assets and buyback stock because you lose a lot of that benefit just with the deleveraging alone.
So.
It's a good theoretical.
Exercise, but you generally need a stock price, it's pretty significantly lower than it is now.
Yeah for the long term I think the dispositions.
Mike.
Yes.
Achieved this year, we think will be it.
Cap rates, where we can be accretive and new investments that improve the portfolio and improve the yield that we're getting on the assets. We're selling so we think that's a better long term use of that capital.
Okay, great. Thanks, that's it for me.
Okay.
Doug I think that's it for the questions. So thanks, everybody there are no other questions.
Yeah. Thanks, Doug we look forward to seeing everybody at the BOMA and NAREIT in a couple of weeks and thanks for participating today.
Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation.
May disconnect your lines at this time and have a wonderful day.