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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings. Welcome to Physicians Realty Trust First Quarter 2019 Earnings Conference Call. [Operator Instructions]. Please note this conference is being recorded.
I will now turn the conference over to your host, Bradley Page, Senior Vice President and General Counsel. Thank you. You may begin.
Thank you. Good morning and welcome to the Physicians Realty Trust First Quarter 2019 Earnings Conference Call and Webcast. With me today are John Thomas, Chief Executive Officer; Jeff Theiler, Chief Financial Officer; Deeni Taylor, Chief Investment Officer; Mark Theine, Executive Vice President of Asset Management; John Lucey, Chief Accounting and Administrative Officer; Laurie Becker, Senior Vice President, Controller; and Dan Klein, Deputy Chief Investment Officer.
During this call, John Thomas will provide a summary of the company's activities and performance for the first quarter of 2019 and year-to-date as well as our strategic focus for the remainder of 2019. Jeff Theiler will review our financial results for the first quarter of 2019 and our thoughts for the remainder of the year. Mark Theine will provide a summary of our operations for the first quarter of 2019. Following that, we will open the call for questions.
This call will contain forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. They are based on the current beliefs of management and information currently available to us. Our actual results will be impacted by known and unknown risks, trends, uncertainties and factors that are beyond our control or ability to predict. Although we believe our assumptions are reasonable, our forward-looking statements are not guarantees of future performance. Our actual results could differ materially from our current expectations and those anticipated or implied in such forward-looking statements.
For a more detailed description of potential risks and other factors that could cause actual results to differ from those contained in any forward-looking statements, please refer to our filings with the Securities and Exchange Commission.
With that, I would now like to turn the call over to the company's CEO, John Thomas. John?
Thank you, Brad, and good morning. Thank you for joining us today. When we last spoke, we informed you of the disappointing closure of the El Paso Surgical Hospital by the operator in late 2018. Both DOC and the on-site physicians learned the disclosure with minimal notice, effectively ending the company's leases on two facilities, a medical office building and a surgical hospital.
Fortunately, we were able to quickly re-tenant the affected MOB under our new tenure lease at terms better than the terminated lease as the physician occupants were reemployed by a wholly-owned subsidiary of Sierra Providence, Tenet Healthcare's wholly-owned subsidiary in El Paso which to then lease the medical office building. Today, we are very pleased to announce the execution of a new 10-year lease with two separate subsidiaries of a major national health system to lease and operate the surgical facility, including the ambulatory surgery center in that building. The new leases will commence June 1 with rent to begin on July 1. The leases are subject to final board approval by that organization, which we expect to occur early in May.
In total, we have fully replaced the rent loss from the prior leases with a better, more profitable healthcare system more tightly aligned with their positions. While we were happy to work with all of the major health systems in town to explore leasing facility, our relationship with this operator in particular was instrumental in turning an unexpected limit and eliminate it very quickly.
We executed this transaction and the new lease efficiently and quickly in a creative win-win structure that benefits the community today and we serve together. Relationships matter, and this is another example of how we invest in better and execute consistently to get better long-term results. We believe in the strength of our experienced underwriting and credit teams and know that even though the most stringent investment criteria will fail to anticipate every tenant to follow. In this most recent circumstance, our credit monitoring process works, proactively identified an opportunity for our leasing team to ensure a positive outcome and preserving shareholder value. While we've continued to work to limit these situations in the future, we hope that you recognize the value in our ability to address them quickly and effectively through our position as the landlord of choice in health care.
We eliminated investments during Q1 2019, with all investments made off market with historical relationships that have credit and will produce more opportunities for us in the future. All these investments have first-year yield exceeding 6% upon rent commencement. We continue to believe we will have a very good opportunity to invest $200 million to $400 million of new investments in 2019, with a portion of these investments being new development starts that will have rent commencing in 2020. All of our development starts or due diligence are leased to an investment-grade credit tenant or anchored by an investment-grade tenant, with affiliated physicians or providers in highly pre-leased buildings.
We believe culture matters, especially the DOC culture. Our team is dedicated to all our stocks and stakeholders, and we have a teeming environment that works very hard everyday in an inviting location where they want to be with people with whom they want to work. Yesterday, we were proud to be recognized by the Milwaukee Business Journal as the coolest office in Milwaukee, which we believe will plot the quality of our 1893 vintage office and the culture of our team. We welcome your bid at any time.
Jeff will now share our Q1 2019 financial highlights. Jeff?
Thank you, John. In the first quarter of 2019, the company generated funds from operations of $47.4 million or $0.25 per share. Our normalized funds from operations were also $47.4 million and $0.25 per share. Our normalized funds available for distribution were $42.1 million or $0.22 per share, $0.01 per share less than the previous quarter. The primary negative impacts to our quarterly earnings are the two major items. The first was a temporary vacancy at the El Paso specialty hospital, which generated $725,000 of cash NOI last quarter. The second was the seasonally higher G&A expense that we have historically seen in the first quarter, which was expected and discussed on our previous earnings call.
With the interest rate theory of lower for longer taking hold again in 2019, there's the increased equity investor interest in Physicians Realty Trust, which has in turn driven our cost of capital lower and supported our stated acquisition strategy. We invested $20 million in 2 loan investments for the first quarter of 2019 at an average first-year yield of 7.7% and completed a $4.3 million addition into an existing building, which will generate 7% yield.
Subsequent to quarter end, we invested another $14.8 million partially funded with OPUs and a 27,000 square foot freestanding ASC in Pasadena Texas, 100% leased through a joint venture of USPI and Memorial Hermann and another $900,000 in a [indiscernible] home we're building in Pensacola, Florida. These new investments collectively yield just over 6%. In summary, year-to-date, we have invested a total of $40 million at an average first-year yield of 7% and remain comfortable with our guidance range of $200 million to $400 million at an average cap rate of 5.5% to 6.25%, assuming favorable capital market conditions. The same assets remain in the inflated predisposition category, with a net book value of $96 million.
Some of these assets are in the early stages of sale negotiations, but not yet advanced enough to provide reasonable certainty of sale. Post quarter end, we closed on 2 dispositions that were the results of unsolicited offers for buildings in Tacoma, Washington and Panama City, Florida. The total net proceeds were $12.5 million, resulting in a gain on sale of $3.1 million. The buildings were yielding a cash cap rate of 6.4% in the most recent quarter and generated an unlevered IRR of 12% during our home period. Our portfolio is 95.4% leased as of the end of the quarter, with 53% of total GLA leased to investment-grade tenants and their subsidiaries. Our same-store NOI grew by 1.5% this quarter. And to preempt the questions we've received in the past, we updated and enhanced our disclosure to allow investors to attract all of our NOI by adding the contributions from assets slated for disposition and repositioning assets. When we included the results of all of those assets, the overall same-store NOI growth would have been 30 basis points higher at 1.8%.
As a reminder, the main negative driver this quarter would be the El Paso Specialty Hospital, which has now been resolved and the tenant is expected to resume rental payment for the second half of 2019. This temporary vacancy costs our portfolio of 140 basis points of same-store NOI growth this quarter and will do the same in the second quarter of the year before payments resume. We utilized the AGM in the first quarter to provide capital for our acquisitions, raising $31 million of net proceeds at an average price of $18.61. Our balance sheet remains strong in 5.8x debt to EBITDA and net debt to gross assets of 34%. G&A expense was elevated this quarter due to seasonal factors, but we remain comfortable with our previous projection of G&A for the year of $31 million to $33 million.
I'll now turn the call over to Mark to walk through some of our operating statistics in more detail. Mark?
Thanks, Jeff. From net operational standpoint, the first quarter of 2019 was another period of stable and consistent growth for Physicians Realty Trust. Our relationship-centric approach to asset management continues to enhance the value of our portfolio, resulting in strong internal growth and a continued commitment to operational excellence through our philosophy of invest in better.
Our portfolio is an industry-leading 95.4% leased, including 53% leased to investment-grade rated health systems or their subsidiaries. This unmatched achievement illustrates our ability to attract and lease space to additional physicians, contributing to an optimized tenant ecosystem so that our partners may reach their clinical and business goals while increasing community access to care. This approach is particularly evident in our ability to release the El Paso surgical facility within one quarter, as John previously mentioned.
Our deep hospital and physician relationships, the strength of the El Paso healthcare market and the premier location of this facility all contributed to releasing 100% of the 89,000 square-foot facility on terms similar to the previously in-place leases.
In addition to the favorable economic impact of this agreement, we are also proud to include green lease provision throughout the new lease. These terms have become standard in our lease template, illustrating our continued commitment to ESG best practices. With the newly executed lease in El Paso, we expect our occupancy to return to the 96% benchmark for which our company is known.
Our $238 million same-store properties representing 89% of the portfolio overall generated NOI growth of 1.5% in the first quarter of 2019. Same-store NOI growth is 2.9% if the El Paso surgical facility is excluded. Over the long term, we continue to expect our same-store portfolio to drive 2% to 3% growth year-over-year as our in-place average rent escalator is 2.3%. In Q1 2019, same-store operating expenses were up 8.5%, almost entirely due to increases in realty taxes. Our corresponding operating expense recoveries were up 8.1%, demonstrating the insulated nature of our cash flow through triple net leases and high occupancy.
With confidence and continued momentum, our leasing team also delivered outstanding results in Q1 2019, completing 171,000 square feet of leasing activity with a favorable 2.1% re-leasing spreads and a 74% retention rate. More than half of the leases signed in the quarter contained annual rent escalations of 3% or more, providing strong internal growth for the future. Tenant improvement allowances for the quarter were $2.06 per square foot per year for new leases and $1.56 per square foot per year for lease renewals. Overall, we invested $4.9 million in tenant improvement in leasing commissions in Q1 2019, representing just 7% of the portfolio's NOI. This conservative investment in capital expenditures relative to our peers is driven primarily by our low lease expirations schedule, which is a key differentiator for DOC that enables us to return more cash to our shareholders.
Looking ahead, just 2% of the portfolio of leases are scheduled to renew during the remainder of 2019 and no more than 7% of the portfolio is scheduled to renew in any one year through the year 2025. Our lease expiration scheduled is strategically laddered, driving predictable growing cash flows for investors for years to come.
Before turning the call back over to John and opening for questions, we quickly like to congratulate Amy Hall, our VP of Leasing, and Jen Manna, our VP and Associate General Counsel, on the new additions to their families and the DOC family. Olivia Miranda Hall [ph] was born April 3 and Sierra Anne Manna [ph] was born April 19. The future DOC certainly looks bright. John?
Thank you, Mark, and 'good work. Thank you, guys. We look forward to questions now, please.
[Operator Instructions]. Our first question comes from Michael Carroll with RBC Capital Markets.
I just wanted to touch on the El Paso leases real quick. I believe Mark indicated that the combined lease is done at similar rents, but the MOB lease is done at better terms. Should we assume that the hospital lease was done at slightly lower terms but net-net, it was better given the MOB results?
On a combined basis, it's slightly better. So slight additional and a slight subtraction, but they average out and, added together, it's more like [indiscernible] we were getting before.
Okay, great. And then, John, how are you looking at the investment market today? Given the competition in the space, where do you see the most value where you can execute deals? Should we assume most of your investment activities is going to be smaller relationship-type deals like the stuff you announced this quarter?
Yes. We're going to continue to focus on the relationship strategy and with the existing health systems. As we've said, all the investments in the first quarter were done with the existing hospital relationships, so our existing developers and existing health system and provider relationships. So that's always going to be our focus. But there's some interesting items, and this is available now in the market. And where we can expand those relationships and create some new relationships. So as I said in my comments, our guidance is still pretty -- we feel really confident about, and there's an uptick in the capital markets in getting really stronger.
And then are there other larger portfolios out there that interest that you think DOC can pursue given the improvement in the cost of capital? Or still the smaller deals are the primary focus?
We look at everything, so it just depends again on the metrics and the strategic value of those opportunities for us. So there's not a lot of portfolios out there that is interesting or exciting to us. We see a lot of one-off opportunities that will accumulate to those acquisition guys.
Okay, great. Then last question for me, can you talk a little bit about the LTACH portfolio? I know it seemed like coverage dropped pretty dramatically this quarter compared to the prior quarter just adding, I guess, 3 additional months to that trailing 12-month calculation. I mean, how should we think about that portfolio? And is there more risk to the LTACHs given that decline?
The LTACH industry has been under some pressure, particularly in the last couple of years with the change in criteria. We feel pretty good about R3. The Plano facility, in particular, is a rock star and does extremely well. It's probably the number one asset in the LifeCare portfolio. The other two have struggled from time-to-time. But they're all having the one master lease, and so we have a good relationship with that organization, but they and other LTACH outside operators are all under pressure right now. So they're certainly something we've continually monitor and evaluated for both either disposition or repositioning. But at this point, Plano really leads the way for us.
Okay. Then what drove the weakness in the coverage ratio? The coverage drops about 1.3 from 2x previously, that seems like a pretty steep decline.
Yes. As I said, Plano continues to perform extremely well, but Fort Worth and Pittsburgh, in particular, lagged. LifeCare has made some changes in the Pittsburgh market, which should help to improve the performance there. And they've also added some service lines there. They started to initiate same in Pittsburgh. Again, we're monitoring all three, but Plano really covers us well and we got the corporate guarantee behind that.
Our next question comes from Jonathan Hughes with Raymond James.
Glad to see the El Paso progress, I know that took a lot of work. Just one question for me on acquisitions and would love to hear from maybe Deeni or Dan on this. But expected pricing on acquisition this year is in the high 5%, low 6% cap rate range, a little higher from the deals over the prior few years and some of the better pricing I get is a reflection of your relationship network. But on the marketed deals you see, have you seen any change in MOB cap rates over the past 6 or 9 months?
Thanks, I'm going to let Deeni respond.
Jonathan, for marketed deals, we're seeing portfolios in that 5.3%, 5.4% cap rate change. If they were individual assets, it'd probably more 5.5% up to a 6%, but that's what we're seeing with the portfolios in the market.
Okay. And maybe a year ago, with those have been more on the low-5 range on the like-for-like basis, which I realize is a hard [indiscernible].
Yes, they were. They could have been that low, it just depends on kind of the relationships that went along with those assets, whether they were health system relationships.
Okay. And I mean, is that just a reflection of the fact that interest rates kind of stabilized upwards, higher here or less demand? I'm just kind of curious which drive maybe a potential expansion of cap rates.
But Jonathan, I think this is JT, I think it's a combination of both. Certainly, the capital marketing have approved for the -- we've kind of come out of REIT bare markets from last year and the rates continued -- tend to be more disciplined and long-term thinking on pricing and IRR expectations from the assets. Probably seeing more private equity sellers than buyers right now, but there's still a lot of private equity up there to pursue some of the portfolio. So I think it's just a combination of all of those matters.
Our next question comes from Jordan Sadler with KeyBanc Capital Markets.
I wanted to just follow up on what happened with El Paso in terms of the income statement, if I could. Jeff, maybe just walk us through sequentially from 4Q to 1Q, what happened and then what we should anticipate in the balance of this year.
Yes, sure. So 4Q to 1Q, you had a reduction of $725,000 of cash NOI. Part of that, there's a little bit of a write off of bad debt expense in 4Q, so the reduction wasn't the full $800,000 that we expected. But going forward, we're going to add about $800,000 or so to the cash NOI line because they're going to start paying that operating expense as well as part of the...
That's in 3Q?
That's in 3Q, yes, sorry.
Plus $800,000 in 3Q, okay. And you said cash NOI declined. Was there also a GAAP NOI decline from 4Q, 1Q?
Yes. There's a decline in GAAP NOI as well, yes.
The same number, pretty much?
Similar.
Okay. I just wanted to -- the guidance, in terms of acquisition guidance in the pipeline, pretty significant. I know your confidence is reasonably high. Can we get a little bit of a refresh on where you stand there, JT, and maybe what timing looks like?
Yes, I think we've got a number of banks in the pipeline right now but just kind of moving towards, kind of finalizing LOIs and putting under our agreement. I mean, there's probably more, obviously, at this time of year, we're going to see more in the third quarter than the fourth quarter. We've got a handful of things we expect to close or going to have to contract this quarter. Like I said, we feel pretty good about the total number. And possibly, $100 million or that $400 million are development starts that we'd either finalized and announced already or in the process of finalizing.
And these are largely smaller one-offs, you were saying, or could we expect to see a couple of bigger chunks in here?
Couple of bigger chunks, couple of bigger assets, but we don't expect -- right now, that number is based upon onesie, twosie transactions. They might be $50 million to $75 million transactions, but a handful in the $25 million range.
Our next question comes from Drew Babin with Baird.
Given the opportunistic ATM raises in the first quarter, as well as assets slated for disposition, would it be fair to say that maybe the upper half of the acquisition guidance range for the year is -- maybe feels a little more on the table than it did a quarter ago? Or do the ATM proceeds maybe just kind of got a substitute for some dispositions that might have happened this year that maybe now happen next year?
Yes. I mean, look, so whatever we put up in this acquisition range, it's always subject to our cost of capital. Our cost of capital improved in the first quarter. We're able to utilize the ATM, which does put that upper bound of the range in play. We can't fund [indiscernible] either with the ATM or recycling some of our assets slated for disposition. Obviously, we'll reduce our acquisition volume accordingly. But right now, it seems very achievable.
Great, that's helpful. And then just a couple of questions on the leasing for the quarter. You mentioned the 2.1% re-leasing spreads. Was that a blended spread with renewals? Or was that just on new leases?
That's on renewal.
Okay. And then lastly, just on expiring leases for both this year and next year. How do you feel about where expiring rents are relative to market and should we continue to expect similar takeups than we've seen just last year and the first quarter of this year? Or do you expect kind of any TDAC in either way as those come up?
Sure, this is Mark. So for the remainder of this year, as I mentioned in the comments, we've got about 2% of our portfolio rolling. The average rental rate, that 2% is $22.29 and then next year we got about 3.5% of our ABR rolling at an average rate of $21.58 per square foot. So I mean, certainly, it's a market-by-market evaluation that we need to do, but those are right in line with national averages for medical office rate, so we expect to renew on similar terms there and we'll continue to push on our re-leasing spreads and building in, in place of players of 2% to 3% to drive our internal growth.
Congrats, Mark, on your office design skills being recognized.
Our next question comes from Vikram Malhotra with Morgan Stanley.
I just wanted to get any color, if there's any updated thoughts post -- or formation of common spirit. Any thoughts on any opportunities with them? Any location that they might be looking to see to, say, move around or to divest of? Any updates there would be helpful.
Thanks, Vikram, this is JT. They continue to integrate that organization. I think integrating it may be faster than most organizations like us would anticipate, but they're still working through some of that as well. So some of the projects we've been working on are on hold, which we would expect in this kind of environment, in the process of integrating their teams. The only thing that we are actively in discussions with them routinely about is global, and they continue to work on the transition of the Louisville, KentuckyOne facilities, Jewish Medical Center in particular. And as publicly noted, they're primarily working with the University of Louisville to transition those hospitals to the university, which frankly would be a pretty positive thing for our MOBs. We feel very confident about the long-term viability and security behind our leases. And we've got some other offers in that market as well. So if that's the one that -- like I said, we don't have anxiety about our leases being maintained there, but we do continue to monitor that as it's where our new operator is going to be and we look forward to that continuation. Other than that, we don't expect any other changes and we expect to continue to garner new opportunities with them, always cognizant of too much concentration in some markets.
Okay, that's helpful. And then just on the El Paso asset, given the new relationship, slightly better rents, et cetera, if you were to sort of market that today, what would that asset sort of trade for on a cap rate or a per foot basis?
That is a great question. It's certainly stronger than it would have been with the old owner. And I think right now, we're just proud to have this tenant in the building, and we'll collect rent from them. But it's more of those that's in the surgical facilities that's going to be a little higher cap rate than MOB. But mid 6s to 7s would be realistic with the quality of this operator and once we get back in there and take care of patients. So we feel very good about both the NIB accretion and the opportunity to work and collect rent to contribute to our bottom line.
Okay, great. And just one quick question, on same store, Jeff maybe. Maybe I missed this -- or sorry if I missed this. The 8.7% increase in OpEx, was that partly driven by sort of the vacancy? And can you just clarify the occupancy impact into 2Q from El Paso?
Sure. This is Mark. The increase from operating expenses in the same-store portfolio is almost exclusively driven by the increase in real estate taxes. Q1, as we've reset the accrual of expenses for real estate assets, so other than $2.3 million increase in our operating expenses, almost $2 million of that is realty tax-related, not related to the vacancy of the portfolio there. And then the change in occupancy will be approximately 89,000 square feet added to our occupancy from the El Paso facility, that was not in there this quarter.
So the 80 bp decline, was that partly El Paso, and then there's something else?
Almost all El Paso and a couple of small leases.
Our next question comes from Chad Vanacore with Stifel.
I just wanted to get some more clarification. Mark, did you say that there'll be excess cost in re-tenanting in El Paso next quarter that we should take into account?
No, sorry, I was saying that the occupancy will come back into the same-store portfolio calculation.
All right. As far as the OpEx, up pretty substantially year-over-year, is there anything in there that comes out next quarter?
No, it's just property taxes. And again, our expense recovery is also increased, 8.1%, again, showing kind of the insulated nature of our triple net leases.
Okay. And just thinking about same-store NOI, you're up 1.5% this quarter. How should we think about same-store NOI trends for the balance of the year?
Yes, it's Jeff. I mean, look, I think the long-term trends, as Mark said in his remarks, our average escalator is 2.3%, largely leased portfolios. We think, over the long term, 2% to 3% is a good bulk for us, and we're anticipating that.
All right. And Jeff, you've trended below there for the past couple of quarters at least. Is there anything that could get you back above that 2%?
I'm sorry, Chad, could you be that question? It's a little...
I'm sorry, same-store NOI, 1.5% this quarter. I think last quarter was 1.3%. Do you have to wait to the back half of the year, where you re-tenanted El Paso to get back above the 2% trend line?
I think that's right, Chad. Because we're not putting El Paso in a repositioning bucket or anything like that, so that's going to negatively impact our same-store next quarter as well -- sorry, second quarter as well. So it starts paying rent again in the back half of the year.
All right. And that probably adds about $0.01 per share FFO in the back half of '19?
Yes. I mean, I think that's about right.
Our next question comes from Daniel Bernstein with Capital One.
Just two questions from me. I think, one, I just want to understand the assets that we've sold in 2Q. Is that part of the assets held for sale at the end of 1Q, or are those different assets?
No, Dan, those are different assets. They were just kind of one-off opportunities to reposition all of our assets [indiscernible].
Sorry, Dan, just to clarify. So they weren't in the slated for disposition bucket, but they were in that assets held for sale categorization because we have -- we have certainty of sale as of 3/31.
Okay. Are you still -- are you actively marketing the 8 assets held for sale?
Yes, yes. We're -- again, we're not in a state where we're confident enough to put them in a held-for-sale bucket in the accounting term, but they are [indiscernible].
Okay, okay. And then the other question I had was on the, I guess, you talked about, I guess, it was almost $100 million, maybe more, of funding of development. I just wanted to understand, is that all kind of coming in the form of development draws on a loan or are you taking any kind of preferred equity stakes? Just trying to understand the structures that are being considered there.
Kind of above, Dan. So the first couple of projects are kind of the construction loans to developer on a 100% pre-leased building to a credit tenant. We've traditionally used either mezzanine financing or kind of a preferred equity position in the capital stacks, depending upon the circumstances. The needs of the developer and the opportunities set, kind of risk-adjusted returns that we're looking for. So it's really a combination of the above, where we're kind of flexible with the both health system tenant and the developer in the middle, so all of the above.
What's the typical yield on those investments maybe between the draws and the mezzanine preferred?
So I think the rent constant going forward is 6-plus for this market and kind of mezzanine, single -- 8-plus, again, depending on the underlying credit, but again, we're only focused on investment-grade type tenants on the back end sort of a little bit tighter, but also at the high end of the -- top end of the capital stakes.
Again, we appreciate your time and attention today. We look forward to your follow-up questions and seeing you at NAREIT. Thank you.
Thank you. This concludes today's conference. All parties may disconnect. Have a great day.