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Good morning and welcome to the HCP Incorporated First Quarter 2018 Financial Results Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded.
I would now like to turn the conference over to Andrew Johns, Vice President of Finance and Investor Relations. Please go ahead.
Thank you, operator. Welcome to HCP's first quarter financial results conference call. Today's conference call will contain certain forward-looking statements. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, our forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our expectations. A discussion of risks and risk factors is included in our press release and detailed in our filings with the SEC. We do not undertake a duty to update any forward-looking statements.
Certain non-GAAP financial measures will be discussed on today's call. In an exhibit to the 8-K we furnished for the SEC today, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measures in accordance with Reg G requirements. The exhibit is also available on our website at www.hcpi.com.
I will now turn the call over to our President and Chief Executive Officer, Tom Herzog.
Thanks, Andrew, and good morning, everyone. With me today are Pete Scott, our CFO; and Scott Brinker, our CIO. Also here and available for the Q&A portion of the call are Tom Klaritch, our COO; Kendall Young, SMD of Senior Housing; and Troy McHenry, our General Counsel.
Our quarterly operating results were in line with our expectations, and this morning, we reaffirmed both our full-year FFO as adjusted and same-property cash NOI growth guidance ranges. Leasing in our specialty office platform is off to a good start, with both our MOB and life science lease pacing ahead of plan.
Our SHOP SPP included the anticipated temporary disruption from the Brookdale transition and sale assets within our relatively small pool of same-stores communities. Importantly, we had already baked this noise into our SPP guidance ranges we provided in February. Pete will provide more details on our performance by segment in a moment.
Since our last earnings call in mid-February, we've made significant progress toward completing the $2 billion of strategic transactions announced in November 2017. We've sold and transitioned certain of our announced Brookdale assets, exited the high-yield mezzanine debt business, and today announced a clear path to exit our international holdings.
Our operator transitions are well underway, and I expect we'll have more progress to update you on soon. Our management team is fully in place, and our board refreshment plans were communicated yesterday. In short, we're on track with all elements of our previously communicated strategic plan.
With the completion of our remaining announced transactions, we will have a fully differentiated and diversified private pay portfolio. Over half of our business will consist of the specialty office segments of medical office and life science. The medical office portfolio is over 80% on-campus and our life science business is well-positioned in the top-three life science markets. Additionally, our senior housing concentration will be reduced to around 40% and will have a stronger demographic profile and lower exposure to new supply.
Our portfolio will benefit from the powerful demographic trends underway, will provide stability through these different cycles and attractive investing alternatives when allocating future capital, while largely eliminating exposure to stroke-of-the-pen risk.
With Scott Bricker joining us in March, we have rounded out a deep leadership team with complementary real state, senior housing, healthcare, transaction and finance experience, supported by a talented bench of highly qualified and motivated colleagues. We remain 100% focused on executing our strategy and positioning HCP as a top-tier healthcare real estate company by meeting the real estate demand for private pay healthcare companies and seniors.
With that, I'll turn it to Pete. Pete?
Thanks, Tom. Let's start with first quarter results. We reported FFO as adjusted of $0.48 per share. Our earnings in the first quarter benefited from higher yielding assets targeted for disposition throughout the balance of the year. We expect FFO as adjusted to decline modestly in the coming quarters, as we complete our planned transactional activity.
Let me provide more details around our major segments. For medical office, same-store cash NOI grew 1.6% over the prior year, which was ahead of our expectations for this quarter. In the first quarter of 2017, we reported above-average same-store cash NOI growth of 4.4%. So we naturally anticipated the first quarter of 2018 to be lower. We expect to improve our quarterly same-store metrics as the year progresses.
On a year-over-year basis, our same-store growth was driven by our 2.7% in-place lease escalators and a 3.9% mark-to-market on renewals, but partially offset by a 40-basis-point decline in occupancy due to some known move-outs. Our leasing pipeline for the balance of the year is strong.
Turning to life science. First quarter same-store cash NOI grew 0.4% over the prior year, which was ahead of our expectation. As we announced on our last quarterly earnings call, the growth was impacted by the mark-to-market of the Rigel lease. On a normalized basis, same-store cash NOI in life science would have been 2.4%.
While occupancy has ticked down from the near all-time high in 2017, year-to-date leasing is well ahead of where we expect it to be. To-date, we have executed leases for LOIs for approximately 80% of our 1 million square feet of leasing slated for 2018. At our recently acquired Hayden Research Campus in Boston, we have executed leases totaling 123,000 square feet since closing the acquisition in December, bringing the campus to 97% leased.
At Phase III of The Cove, which consists of 336,000 square feet of Class A specialty office, I am pleased to report today that we have leasing commitment for 100% of the space, well ahead of expectation. This milestone is another example of the strength of the South San Francisco life science market, combined with the unsurpassed quality of this best-in-class campus.
Lastly, in April, we signed two new leases totaling 150,000 square feet with General Atomics at our Ridgeview development located in the San Diego suburb of Poway. The $62 million development is now 100% leased to General Atomics.
For our senior housing triple-net portfolio, same-store cash NOI grew 0.5% in the first quarter. This was in line with our expectations and takes into account our previously announced rent adjustment. On a normalized basis, same-store cash NOI in senior housing triple-net would have been 2.3%.
For our SHOP portfolio, same-store cash NOI for the quarter was negative 6.4%, which was in line with our expectation. Given the occupancy declines we experienced in the second and third quarters of 2017, we were not at all surprised by these results. Importantly, too, we do not exclude or normalize for performance in our transition assets or assets we are marketing for sale.
While we experienced an overall decline in occupancy of 200 basis points, the performance in our core long-term portfolio and our transition and sale assets were dramatically different. Transition and sale assets typically underperformed due to expected higher turnover in key operational positions, which can lead to significant temporary impact on property performance. Page 32 of our supplemental provides a breakdown of this bifurcated performance.
For our core portfolio, we experienced a decline in cash NOI of 0.6% which was the result of 70 basis points lower occupancy, 2.1% REVPOR growth and 2.2% expense growth. For our transition and sale assets, we experienced a decline in cash NOI of 12.3%, which was the result of 310 basis points lower occupancy, 1.4% REVPOR growth, and 3.1% expense growth.
As a reminder, our SHOP SPP portfolio consists of only 69 assets, which will be reduced further as sales are completed, and is approximately 10% of our overall NOI. Small nature of the pool results in increased volatility and performance as well. We remain committed to reducing our Brookdale exposure to 16% or lower of our overall portfolio income. We look forward to getting these assets transitioned to operators who we believe will improve performance.
We are well underway to achieving this, having completed 13 transitions to Atria, with the remaining scheduled through early summer. Additionally, we transitioned one community to another existing operator, Sonata Senior Living. We are also nearing agreement with a select group of operators to take on the balance of the transition assets. On our third-party sales, we are in the midst of our marketing process.
Let me briefly touch upon some accounting items related to the UK transaction which we announced concurrent with today's earnings. In March 2018, we consolidated seven UK care homes but with the underlying security for our £105 million bridge loan to Maria Mallaband. If you recall, this loan includes a provision that allows us to convert the loan to real estate, provided certain conditions are met. We received feedback from potential buyers that they would prefer to acquire the real estate directly rather than through the debt investment.
Consequently, in March, we began the process to exercise the option to convert the loan to real estate. And, upon satisfying the required conditions, we consolidated the real estate at fair value in accordance with accounting rules, resulting in a loss on consolidation of £29 million. The current fair value of the real estate was adversely affected by a temporary decline in occupancy and embargoes.
I would also like to point out that upon closing the joint venture transaction, which Scott will cover in more detail, we expect to recognize a gain of approximately £20 million upon marking our other 61 assets to market in accordance with accounting.
Moving on to the balance sheet, we ended the quarter with a revolver balance of $1.1 billion. Subsequent to quarter-end, we closed on the sale $270 million of assets. Using the sales proceeds, we paid down our revolver, bringing the balance to approximately $800 million as of May 2. Pro forma for this pay down, our first quarter annualized 2018 net debt to adjusted EBITDA would be 6.5 times.
Turning to the dividend. As previously announced, company's board of directors declared a quarterly cash dividend of $0.37 per share to be paid on May 22. As a result of our high quality portfolio, we are very comfortable with our current dividend payout ratio in the low-90% range for 2018. This payout ratio will vary by quarter, but we expect to remain fully covered on a quarterly basis through the balance of the year.
As we look beyond 2018, our payout ratio will benefit from approximately 3% contractual escalators on the vast majority of our portfolio, the significant near-term positive mark-to-market lease opportunities in life science and the substantial earn-in from key development projects, including The Cove.
Finishing with our full-year guidance, we are reaffirming our FFO as adjusted per share range of $1.77 to $1.83 and total cash NOI SPP of 0.25% to 1.75%. Additional details of our guidance can be found on page 46 of our supplemental.
One last item before turning the call over to Scott. As we discussed on our last quarterly call, in order to create greater comparability to our peers, we have excluded unconsolidated joint ventures on same-property results. Starting this quarter, we have collapsed all of our unconsolidated joint venture disclosures in the supplemental to one section on pages 43 to 45.
Additionally, please refer to the SPP reconciliation table on page 15 of the supplemental to see the adjustments to our SPP pools as a result of this methodology change. As a reminder, given the small amount of unconsolidated joint ventures, this reporting change had minimal impact on our overall SPP results.
Now, I would like to turn the call over to Scott.
Okay. Thank you, Pete. I want to kick off with an update on transactions. The story here is execution. In March, we completed the sale of our Tandem mezzanine loan for $112 million. We're very happy to be out of the freestanding skilled nursing and mezzanine loan businesses.
We closed the sale of six properties back to Brookdale for $275 million, with most of that occurring in April. We're also on track to close the sale of our JV interest in 48 Brookdale properties to Columbia Pacific this summer, which will generate $332 million in proceeds to HCP.
We saw some good progress in the UK. Earlier this week, we signed a purchase agreement with an institutional investor to sell a 51% interest in our UK holdings. The price is based on an enterprise value of £394 million. We expect to close the JV this summer and we have a clear path to a full exit from the UK by no later than 2020.
The proceeds from the asset sales will be used to pay down debt and to help fund our highly desirable life science development pipeline. Last quarter, we funded $72 million into that pipeline, which will provide growth in earnings and NAV when the projects come on line.
Now eight weeks in, I wanted to share a few things about HCP that stand out to me. One is that the team is united and highly energized to start talking about the future. Another is that we're emerging from this transformation uniquely balanced in life science, medical office and senior housing. All three segments benefit from undeniable and long-term trends in healthcare demographics. We have critical mass and expertise in all three segments.
I also see great upside in changing the public narrative about HCP away from the noise of the repositioning, and toward the valuable and unique real estate that remains. After seeing some of that real estate firsthand, one thing that stands out to me is the density of many of our campuses. You can park your car once and walk to five or more HCP buildings. Each tenant plays off the success of the other, creating a virtuous cycle of demand for space.
An example is Medical City Dallas, a 2.1 million-square-foot HCA-sponsored campus with seven buildings, all of them owned by HCP. It's one of the leading medical campuses in the entire country and would be impossible to replicate today given the location and scale. Another example is Centennial, our 600,000-square-foot cluster of seven fully occupied MOBs on the campus of HCA's flagship hospital in Nashville.
Our life science campuses were equally impressive to see in person. Their scale and density give us flexibility. This is super important because space requirements can change dramatically over time based on drug approvals and new funding and partnerships.
A good example is at The Cove, a one million-square-foot campus of seven buildings developed by HCP in South San Francisco. This week, we signed a lease for 150,000 square feet with an existing HCP tenant. After a successful IPO and signing multiple new partnerships, that tenant was looking to expand its footprint by 400%. Our local scale enabled us to meet their needs. The expanded lease will commence next April when our newest development project is completed.
And directly adjacent to The Cove is Oyster Point, our nine-building campus with just under 1 million square feet. The most unique property I saw was in Mountain View, where our cluster of 12 fully occupied buildings fit like a jigsaw puzzle within Google's corporate campus. The scale of these five campuses is truly unique within healthcare real estate and they generate an incredible $200 million in annual NOI to HCP.
I also want to share some initial thoughts on capital allocation. First and foremost, we'll be focused on owning high-quality real estate that allows us to grow the dividend over time. We won't see earnings growth that's achieved through financial products and engineering, which in our view have a track record of starting accretively but ending destructively.
We're going to be more mindful of concentration by segment, by tenant and by geography. REITs at their best consistently grow their dividend, but we know that sector fundamentals change, operators change and markets change. Diversification will help us mitigate the big swings up and down. Our underwriting will be thorough and objective, and our investment decisions will focus on risk-adjusted cash flows over time.
Our portfolio mix will shift to a more equal balance between life science, medical office and senior housing. That means near-term capital allocation will be toward life science and medical office, and primarily new development and redevelopment, where we currently see the best risk-adjusted returns.
We like the mix of the low-volatility medical office business with the potential for higher growth in life science and senior housing. The cyclical drivers of these three segments are very different, so the diversification is meaningful. Over time, we may see a step away from our small hospital exposure other than Medical City, but we're in no hurry to do so because we never lose sleep over the assets, given very strong rent cover and corporate guarantees.
Finally, I've been asked to share my thoughts on senior housing. Obstacles aren't new to the sector. Today, the environment is difficult and it likely will remain so for the next few years. New construction has started to decline, but off a very high base. So the absolute number is still elevating. There needs to be a more significant and sustained slowdown in new starts before we would feel confident about the sector returning to strong growth in earnings.
We're confident, though, that over time capital inflows will correct, allowing demand to catch up with supply. Therefore, senior housing is an important part of our long-term strategy. We like the fact that demand for the product is growing. It's becoming harder and harder to find a family who hasn't been impacted by senior housing. And that phenomenon will only increase because the senior population will double in size over the next two decades and the penetration rate is rising.
We also like that senior housing is an inefficient market and by that, I mean, there's imperfect information. That opens the door to outperformance through expertise and relationships. We expect to become one of the outperformers through five major initiatives. One, by selling select assets and transitioning others to new operating partners, most of which has already been announced; two, by converting select high-quality triple-net portfolios with strong growth potential into SHOP; three, by redeveloping select older physical plants that are located in tremendous locations; four, through smart acquisitions, new development and operator relationships; and five, by establishing a superior asset management platform led by data, analytics and relationships.
Before I turn it back to Tom, I just want to say I feel very fortunate to have joined HCP at this point in its life cycle, poised to once again generate significant value for shareholders.
And now, back to Tom.
Thanks, Scott. Before we open up the call to questions, I'd like to address a number of important changes to our board of directors. Yesterday, we announced that Brian Cartwright was appointed the Chairman of the Board. Dave Henry, who has served on HCP's board since 2004 and recently as Interim Chairman, will provide his extensive investment and transaction experience to chair the Investment and Finance Committee of our board.
Brian has been on the HCP board since 2013. His background and experience are unusually extensive. Brian served our country in a top leadership role as General Counsel to the Securities and Exchange Commission from 2006 through 2009, a period of time which you'll recall included the incredible challenges of the global financial crisis.
Prior to the SEC, Brian was a member of the senior executive team that built Latham & Watkins from a local Los Angeles firm into one of the top law firms in the world. And before Latham, he started his career with a Ph.D. in physics, post-doctorate in astrophysics and, finally, a law degree. In his spare time, he was the President of the Harvard Law Review and served as a law clerk for Sandra Day O'Connor during her first term on the Supreme Court. As I'm sure you can ascertain, Brian has been an incredible talent and resource in our boardroom.
We also announced the appointment of two new highly-qualified and accomplished directors to our board, Lydia Kennard and Kent Griffin. Lydia's professional experience spans corporate law, real estate development and urban planning. She served as Executive Director of Los Angeles World Airports from 1999 through 2003 and again from 2005 to early 2007.
In this role, she oversaw and managed the country's second largest airport system, which included four airports, a staff of more than 3,000 and an annual budget of nearly $1 billion. Lydia is currently President and CEO of KDG Construction Consulting, a program and construction management and consulting firm.
Kent is a seasoned REIT executive, having served in the role of President and Chief Operating Officer of the life science REIT, BioMed, from 2008 until 2015. Prior to BioMed, Kent spent eight years as an investment banker at Raymond James and JPMorgan, following his time as a CPA and auditor at Arthur Andersen. On behalf of HCP, I'd like to welcome Lydia and Kent.
Finally, our board recently adopted a mandatory retirement age of 75, subject to limited exceptions to ensure an orderly transition of new members. This policy is in line with corporate governance best practices and one that ensures continued board refreshment over time. It's worth noting that with the addition of Lydia and Kent, half of our directors have joined the board within the last five years.
With what I believe is an excellent management team and board, and a strategically positioned portfolio, our sights are squarely set on delivering long-term stable growth and strong total shareholder return. It is an exciting time for HCP.
With that, operator, please open up the line for questions.
Thank you. The first question comes from Jonathan Hughes with Raymond James. Please go ahead.
Hey. Good afternoon or good morning up there actually. But thanks for the time and earlier commentary.
Pete, earlier, you talked about departures at the transition sale SHOP portfolio that was part of the driver of the decline in NOI there in the quarter. But I thought part of the strategic review of those assets late last year was to add managers and specialists to help stabilize operations. So I know some will be sold, but could you just talk about maybe what happened there in the quarter and if the strategy on those assets changed at all?
Yeah. Hey, Jonathan. How are you? I think one of the things to point out on the transitions and dispositions is, when you look at the year-over-year comparison, a lot of the occupancy decline actually happened last year. So we had anticipated those assets underperforming.
We've started the transition process. We've got, at this point in time, 13 transition to Atria, although that's happened very recently, 1 to Sonata. It will take some time to see performance turn around at those assets. So I think the point is, the decline was kind of baked in already and the upside will come as these operators have more time to actually operate these assets.
Okay. That's helpful. And then, the SHOP portfolio is currently 13% of NOI, and I thought the target exposure there was 20% at least back in November. What's the target there, considering you still have several hundred million left to sell this year, more like 10%?
Yeah. I don't know that we necessarily have an exact target. As we look at our portfolio right now, and the SPP pool is a little bit different than the overall exposure. As we look at senior housing as well MOBs as well as life sciences, over time, we're trending more towards specialty office right now. I think we'll look to have a more even blend amongst all the segments as well and more of a medium- and long-term goal that we'll have trying to have more of a third, a third, a third split.
And I think it's hard to just say how much SHOP will be. Some of that will also depend upon over time, and as Scott talked about in his prepared remarks, triple-net assets converting into SHOP. So I think, as we look at it, that's basically how we see our portfolio trending over the long-term.
I think, Jonathan, the other thing within that number that could get confused is the CCRCs and their exclusion from SHOP. As you'll recall, we moved those into a separate bucket and we're guiding to those separately in our guidance page at this point. That might be the difference that you're seeing there.
Yeah. Okay. And then, just one more if I may on life science. But the appointment of Kent Griffin to the board who has a deep background in the sector, was this done to try and specifically break into the Boston life science market in a more meaningful way? And if so, kind of do you expect that to be more development- or acquisition-focused? Thanks.
Yeah. This again is Tom. With Kent joining the board, he brings a very specific expertise in the executive background around life science. He was, as I said, the President and COO of BioMed. Prior to that, he was the CFO of BioMed.
As to specifically Boston, yeah, I think that Kent's knowledge and contribution in all three of the major markets that we're participating in is going to be helpful to our management team and in the boardroom. So, that was one of the very attractive elements of expertise that Kent brings to the board.
Okay. That's it for me. I'll jump off. Thanks, everyone.
Thanks, Jonathan.
Thanks, Jonathan.
The next question comes from Juan Sanabria with Bank of America. Please go ahead.
Hi. Thanks for the time. Just on the Brookdale sales to third parties, can you give us an update on how that's progressing, the depth of the buyer pool, if initial color is that you're going to achieve your targeted proceeds and cap rates? And if you can just give an – and is that a portfolio or kind of one-off sales that will aggregate up to your target?
Hi, Juan. Scott Brinker here. It's to be determined. We're talking to a number of parties about the assets. Our preference is to do something in scale, but we're open-minded to alternatives. There are a number of parties that are interested in the portfolio. They would have the ability to bring in their own operating partner here. So these assets would be acquired unencumbered by the Brookdale contracts.
But I don't want to say too much more than that, Juan, because we're in the middle of our process, and we would hope to have more significant updates for you in coming months.
Okay. Great. And then, Scott, maybe if I could stick with you just on, if I think about asset management and areas of improvement, like, what would you highlight as something that you think you can improve given your past experiences? And are the operators receptive to that, particularly Brookdale in those discussions in benchmarking best practices?
Yeah. I'm happy to answer that, Juan. I think there's a great opportunity here. HCP was historically more of a passive triple-net landlord. And Tom and the team have really made tremendous strides in the last 18 months to change that into what will become a best-in-class real estate operating company. But there's still some ways to go. And we're confident we're going to get there. It's happening rapidly. But it's a combination of people and technology and relationships with operators.
There's also the issue of the size of our pool. So it bounces around a little bit, in part because it's so small. And that's something that in senior housing is difficult to manage even if you had A-plus team across the board. It's just a small pool and you're naturally going to have some movement, given the dynamics of the sector with short lease terms, relatively low margins, and it's very unpredictable from month-to-month.
So you're going to see that number jump around a little bit, even after we improve our team, which we will do. But important to note that it is a relatively small percentage of our portfolio and we think that's the right place for senior housing within a broad diversified portfolio.
And just one more follow-up...
Juan, this is Herzog again. I'll just expand just a couple of items, and this may just come as a reminder to comments we've made in the past. But we've just spent the last quarter working on it. Still, we have dramatically enhanced the team. That includes the asset management team. We have continued to build a dedicated finance team in senior housing. We've been rapidly building out a system that is functional at this point that is going to be a great help in our analysis of senior housing and our reporting and tracking.
And the senior leadership that we brought in has continued to have some time in the role. And as you know, from an operator perspective, we have been very active in taking actions on that front. So, everything that Scott said are things that he's focused on now, along with Kendall and the team. But there has been a lot of activity in the last quarter.
Thanks. And one last one for Scott, and welcome back by the way. You made a comment that supply may be elevated for a few years. So do you have any sense or color or share any thoughts on what you think the medium-term same-store NOI growth for the sector as a whole could be, just given supply will probably be higher for longer?
Yeah. Juan, I'm happy to comment on that. And individual companies will be above or below the national average. It's along the lines of my comment earlier that it is an inefficient market and we see quite a bit of variation in performance. But as an industry, I guess I look at supply that's been growing around 3% per year, a little bit more actually, and it's starting to come down but not meaningfully. Meanwhile, demand has been growing around 2% per year for a decade.
Over time, we think that growth rate will increase pretty materially from the 2%, but not next year. And it's probably a five-plus year period of time before there's truly significant increase in that demand growth rate. It's our best guess at the national level. And that's why we look at the supply-demand picture nationally, and maybe aren't quite as optimistic as others that the industry at large is going to have a material turnaround in performance in 2019.
Now, all that being said, at HCP, I think we've got significant opportunity with the operator transitions. And as those assets recapture their occupancy and ultimately we think move even beyond what they've achieved historically with better operations, not to mention all the improvements in asset management that Tom and I described earlier that, look, we think we have a real chance to outperform the sector for a period of time here. But, at the national level, Juan, I guess we're a little bit more cautious about how quickly things can turn around.
Thank you.
Sure.
Okay. The next question comes from Smedes Rose with Citi. Please go ahead.
Hey. It's Michael Bilerman here with Smedes. Just a question on the UK deal. What was the structuring to not try to exit 100% upfront? And then, can you talk about the next couple of years in terms of how the sale of your remaining 49% interest will be triggered and how that will be priced?
Yeah. I'm happy to take that one, Michael. It's Scott Brinker here. We did run a sale process for this portfolio. Like any seller, we looked at a number of factors that were relevant to us, like price and certainty of execution and timing. And, ultimately, we chose a buyer that we thought offered the best combination of those things.
So our view is that this is really a full exit. It's just going to happen in stages. So we like the fact that we got what we think is a fair price for these assets. About a 6.5% after-tax yield to HCP, we think that's very fair.
The initial closing should be this summer, which met our timing needs. And we were able to have a negotiation with the buyer and meet an important consideration for them, which was to lock up the deal but have the time needed to do a full takeout, which is their expectation, it's our expectation. It could happen as soon as this year-end. At the latest, it should happen by 2020.
And what is that? Do you have a put right by 2020 at the current price?
Yes. So the way the mechanics work, Michael, is first, this is an institutional investor that's well known to HCP and to me. And it will, in practice, be more consensual and we'll have a discussion. But we do have contractual rights that would allow us to force an exit of our 49% interest.
And the way the pricing works is, because this is a triple-net lease, the rent continues to escalate. So their purchase price continues to escalate. And if the performance was to decline quite materially, there would be an adjustment in the purchase price. But we do have a pretty significant cushion in terms of how much the NOI can fall before there would be a downward adjustment in the price.
And then just turning to the triple-net master lease portfolio, pages 26 and 27 of the supp. The percentages that are below that one line are growing in terms of exposure. And when you look at page 27, outside of solving the Brookdale coverage issues, all the other ones are quite low.
So, I guess, how should the market be thinking about further net reductions? The senior housing operating fundamentals do not seem to be getting any better any time soon. And so how should we think about the security of that rental stream?
Yeah. Michael, it's Scott Brinker. I'll take that one as well. We view those as really having a number of options. The two most significant, one of them is only slightly below 1.0 coverage, and that's after our management fee.
So, even if we were to renew the lease, I don't think there would be a material change in rents. And like a lot of these pooled master leases, there are often times one or two properties that are really causing the problem, and the balance of the portfolio is actually performing quite well. And that's certainly the case in a number of these.
So you would always have the option of just selling one or two underperformers and keeping the rest. We could transition operators. We could transition to SHOP. So, none of these have immediate expirations. We've got two or more years to figure these out. I can assure you it's a high priority for us.
But we're also not feeling any urgency to do something because a number of these do have strong guarantees, and the two on the list that don't, I think this graph is a little bit misleading or misrepresentational about the underlying cash flows because the two that you see on page 26 without the guarantees, the actual rent that we're collecting is materially lower than what's reflected here.
It's this historical or legacy triple-net add rent lease that we acquired from CNL that, at the end of the day, the cash rent is what we're booking, and that means the coverage is right around 1.0. So those two are I think a little bit misleading in terms of the payment coverage.
And then just last question. The down 12% on the SHOP portfolio that's being transitioned or sold, can you break out that down 12% between the assets that are anticipated to be sold versus the assets that are being transitioned, just to know how those different pools performed in the first quarter, because it seems like a much steeper decline than one would have expected?
Yeah. Hey, Michael. It's Peter here. I would just say, broadly, when we look at the transitions and dispositions, there are 34 assets. That's probably a 50%-50% split when you think about transitions versus dispositions. And I don't think there was a material difference in performance. It was sort of pretty consistent within both of those groups.
Okay. Pretty consistently poor.
Yes.
And the idea is that that's going to keep on trending that sort of rate until these things are sold or transitioned?
Well, I think on the transitions, we would expect to see some benefits, especially on the earlier ones that we have completed already towards the end of the year. On the dispositions, I think what I would say is those assets, as we are looking to sell them right now, I guess it's somewhat irrelevant how they're going to trend going forward for the buyer.
I mean, the buyers we're talking to at this point are all underwriting it based on a new operator taking over those assets. So they're not necessarily looking at what Brookdale could do with those assets, it's what the new operator could with those. So I think you really need to take a look at the differences between the way that Brookdale is operating those and what the expectations would be for a new operator.
Well, if you can just break that stuff out going forward for us in terms of sale versus transition, because I definitely think there's a lot of uncertainty when a new operator comes in. It takes a while for those benefits to see fruit. Typically, it goes the other way to a more significant extent early on as a new manager comes in. So, having the details between those two pools would be helpful. Thanks.
Yeah. Michael, we would have done that if not for the fact that we're in the middle of the sale process on half of assets. Obviously, providing that detail is something we didn't want to do.
The other thing I would mention – I know you cut it in the first time it was said, but in those results that you just spoke to, in the prior year most of that was baked in due to the comp where Q2 and Q3 occupancy had declined in the prior year. So, that's what drove the whole piece of it, which is a great part of the reason that we had selected those assets for sale and transition.
Okay. Thank you.
You bet. Thank you.
Okay. The next question comes from Jordan Sadler with KeyBanc. Please go ahead.
Thank you. Good morning out there. I wanted to just follow up, I guess, another one for you, Scott, on the portfolio overall and some asset management commentary regarding the senior housing portfolio.
Your fundamental description sounds not exactly dire, but not exactly bullish for the next five years. And given sort of the company's ongoing process of trimming assets and paring the portfolio, is there consideration or thought of scaling down the senior housing side of the business to a much more significant extent in the short-term? Is that on the table?
Well, there are a number of asset sales underway, Jordan. So, without question, our goal as a company is to create a more even balance between senior housing, medical office and life science. We're well on our way towards that path.
And as I mentioned earlier, there will be pockets of outperformance, which is why we chose to sell the properties that we're selling and to transition some other properties that we think have the potential for outperformance going forward.
So we'll continue to look at what's left, match that up with our relationships with operators and we'll constantly be looking at this portfolio to better position it to outperform. And the asset management is an important part of that. It shows the real estate that we own and the operating companies that we partner with.
So I don't think you should expect anything dramatic, but you should expect continued work to position this portfolio, I think, more effectively.
And, Jordan, this is Herzog again. I would add that, as we complete the transactions, it'll bring our senior housing down to 40% of our portfolio or just under that. And as we look at what's dialed in, just to what our expectations are as we continue to work our plan, it will be naturally reduced without doing anything dramatic as we further expand the life science and MOBs. And I think you'll see that percentage decline, the senior housing ownership percentage decline over time some.
But we still like the business. We still believe in it over the long-term. We think it is an important private pay segment within a balanced portfolio that we want to own long-term. So it's probably over time, more of a third, a third, and a third between life science, MOBs and senior housing over time, without a specific target date. And some of that just occurs as we continue to recycle capital into life science, into MOBs, some of it through development on life science, et cetera. It'll naturally move that direction and there'll be certain actions that we take carefully over time that I think probably move us into that balance that we've been speaking to for a while.
Okay. And Tom, I do have another one for you just on – you've now got much of the management team in place. It seems that you're aiming for and the board has now been recast somewhat.
I'm curious, number one, vis-à-vis earlier comments about making the company more of a real estate operating company, is there a similar desire to add to personnel on the operating side, either on the medical office or life science side, or are you all set there? And then any update on Doug Pasquale's consulting role?
As far as adding operational talent, that's something we've been doing for the last year. And I would see us continue to lean that direction over the next couple years as we continue to enhance our platform and infrastructure, round out operational talent, as you put it, that we really view ourselves as a real estate company in the healthcare business and having great operations is going to be critical to our plan.
So the answer to that is, yes, we do intend to do that. There'll be a lot of focus on not just the team, but the rest of the platform and infrastructure including systems, processes, et cetera. So, that will be a focus. And I think it's going to be a very important element of what drives a success in our sector going forward.
As to Doug Pasquale, he is an excellent talent in senior housing. As you know, he's both run one of the major REITs in healthcare and was an operator in senior housing. So, Doug continues to be a part of the team that we're working with and there's nothing that's changed on that front.
Okay. Thank you.
Thank you.
Okay. The next question comes from Rich Anderson with Mizuho Securities. Please go ahead.
Thanks. Good morning, everyone. So I want to see if I can get into your senior housing head for a second here. On the transition of net lease to SHOP initiative, how much of that is, well, we're close to 1.0 coverage and I don't want to cut rent, so let's move to SHOP; or how much of that is a true belief in SHOP over triple-net? And I'm curious if you were at 1.3 coverage, would this be as much of an initiative that you plan it to be today?
Hey, Rich. It's Scott here. Yeah. I wouldn't call them initiatives. I would call it an option.
Okay.
It's one that could make sense or...
They made your top five, so.
I think the one that might make sense for us is the portfolios. And one of the things I noticed about the portfolio that it's maybe a little bit different than what I would have thought about it 5 or 10 years ago, is that HCP has some very high-quality real estate inside the triple-net portfolio and some very high-quality operating partners, like Sunrise and Aegis and Oakmont. And those could well be opportunities for SHOP.
It doesn't mean that we will do that, but it's an opportunity that I think these are assets that had performed over time. They continue to outperform during the recent down cycles, that if we're going to have SHOP, one of our goals will be to have higher quality real estate and higher quality operating partners. And it may well be that we can accomplish that by transitioning some of our triple-net portfolio over to SHOP. But it's definitely not an initiative. It's just something that we would do if it makes sense from a valuation and performance standpoint.
But the one Oak, if it's something that's close to parity in terms of coverage, that plays a role like balancing, cutting rent and moving to SHOP. It certainly is a motivating factor I would assume.
Yeah. It's more the lease maturity date that would be a motivating factor. Certainly, the cash flows are something that would factor into the conversation with the operator because we don't have the right to unilaterally switch to SHOP.
Yeah. Right.
That would be a two-way discussion and conversation. And if the cash flows are around 1.0 rent cover, it is an easier conversation to have.
Okay. Okay. Good enough. And then, another question. On the Brookdale strategy, you mentioned, I think it was Peter, probably all of you, getting to 16% or lower. What do you think of the criticism that that's not enough, that you're still a proxy for Brookdale even at 16%? And what's the over-under of going much lower than 16% when it's all said and done?
Richard, I'm going to compliment you for your listening skills because that was a very quick comment but perceptive on your part. Yeah, we said 16% or lower. We do intend to get to the 16% from what we've already dialed in to the transaction that we've announced. And there may be some opportunities to reduce that over time.
It's not that we're in a rush to do so. We're positioned well right now. But I do think over time that we will be assessing it, we'll be working with Cindy Baier and her team. And there are opportunities to reduce that concentration in a few different ways. So those will be things that we will be discussing.
I noticed when Ventas did their deal, they kind of were stepping down their rent concessions over the course of eight years. And I was wondering if that strategy resonated with you at all as a mechanism to pursue something below 16% at least on the triple-net side, or maybe it didn't at all. Just curious.
No. It's a good question. It doesn't at all for us. Our coverage on our triple-net is in the 120s. When we recut that deal with Brookdale, Kendall and the Brookdale team had taken actions to boost our coverage quite strongly. And so, as far as – in our fact pattern, utilizing the same approach wouldn't be relevant for us.
Okay. Thanks very much.
All right. Thanks, Rich.
Okay. The next question comes from Michael Mueller with JPMorgan. Please go ahead.
Thanks. Hi. Just curious how you're thinking about acquisitions at this point relative to your equity pricing, once you go through and deploy all the proceeds from the sales? So, just thinking about that heading on down the road.
Hey, Michael. Scott Brinker here. We're not really thinking very seriously about raising external capital. Right now, we think there's a lot of value to be captured with improved performance and execution, before we think about growing with new capital. We are in the process, of course, of raising a lot of capital through asset sales. And the primary use of proceeds right now is to pay down debt and to fund a very attractive development pipeline and redevelopment opportunity in the medical office and life science segment.
So we're looking at the market. We intend to be buyers at one point in the future. But I wouldn't expect to see us be extremely active buyers in the acquisition market today really in any of the three sectors. All that being said, there could be unique opportunities within medical office and life science and either key markets that we're already in or markets that we'd like to be in. That could be interesting, but again, with recycled capital rather than with new capital.
Got it. And just one clarification on the UK transaction. I know the transaction, the second tranche can come down by 2020. Is that by January 1 or 12/31/2020?
So, Mike, Scott Brinker again. The expectation in the contract would say by year-end 2019. We have the right to force an exit. We're hopeful and optimistic it'll actually happen before that, and so is the buyer. But it is year-end 2019, not year-end 2020.
Got it. Okay. Thank you.
You're welcome.
Okay. The next question comes from Vikram Malhotra with Morgan Stanley. Please go ahead.
Thanks for taking the question. So, Scott, just maybe sticking on senior housing, you kind of referenced supply-demand in the outlook. Is your view that we have reached the low point in seniors housing, but it's going to take a little bit longer to see upside? Or do you think we're going to see incremental deceleration or declines in the NOI from here, and maybe at an industry level and then specific to HCP?
Hey, Vikram. It's not so much that we expect it to get substantially worse. In fact, we expect, at least for HCP, for things to get better and hopefully significantly better. But, at the industry level, it's more that the trough might last for longer than the market is expecting, is our general view, just looking at population growth and supply. It's leveling off but not in any significant or material way.
And the other thing that I noticed is that the traditional higher barrier to entry markets are starting to get a fair amount of supply as well, like New York and Northern New Jersey or Seattle and Washington, D.C. in particular that for years had very little new supply, and now even those markets are getting a fair amount. So I think that we're monitoring as well.
Okay. And then one of your peers obviously restructured their lease with Brookdale. I'm just wondering, taking a step back, given what we've seen happen to RIDEA growth, but also just the triple-net segment, despite the last maybe five or six years, EBITDAR has rarely grown above maybe 2% despite the strong housing market.
So, as these maybe leases come up and it maybe a while, maybe three years or five years, do you think the economics of these transactions or these agreements need to be changed substantially where the rent bumps are a lot lower, you have more covenants in for types of CapEx that you need, and maybe just other changes so that we don't end up into the same situation, if you see supply remaining elevated for a longer time?
Yeah. I'm happy to answer that, Vikram. Most of the triple-net leases that you see are really legacy arrangements. It's very rare to see a landlord and a tenant enter into a brand new lease agreement. They might recut an existing lease, but that at least in our view is a financing arrangement that made sense in senior housing a decade ago. We just don't see many triple-net leases being entered into today. If you did, I'm sure they would be setting rents at much lower levels with a bigger cushion and adequate cash flow to invest back into the properties and to create a reasonable alignment of interests and incentives between the landlord and tenant.
Our portfolio is, at least once the Brookdale restructuring is done, will be above market. But if I was to start from scratch, I think we'd prefer to be substantially higher than that at, right, at 1.13 times after a management fee. That looks pretty good versus the industry but it's still relatively tight.
But you also haven't seen us do a triple-net lease in probably 10 years, and I don't think it's likely that you'll see a lot of those going forward.
Okay. And then just one more, I mean, maybe this is for the broader team, Tom, you as well. And, Scott, if you were sort of in your former role or you had the opportunity where the deal that Welltower did recently on the skill side were presented to you, what factors would you really consider as to what you'd like about sort of a similar transaction? What would you say, no, this makes me sort of stay away from?
I have to verify. I reckon you talked about the Welltower transaction, is that what I heard you say?
That's right.
Yeah. I'd tell you I hate to – I probably take that question kick that over to the Welltower folks to answer that. I will tell you that from where we sit, as we think about our QCP spend, we are very pleased that we did get it spun off. It was a good result for us. We put it in the hands of Mark Ordan and his team where they had more flexibility in what they could do with the portfolio.
You've probably noted, if you're following the transaction, that prior to the announcement with Welltower that they were going to put the (1:04:31) together again, which that's not something a REIT can do. So they had other alternatives, what was part of our mindset when we did the original spend that could create value. And we are just really pleased to see that they did end up with a good outcome on behalf of our shareholders that stayed with QCP. We think that it certainly provided a nice bump in the most recent news. So, that's probably all I would say on that transaction.
So, scale probably is not part of the equation for HCP going forward?
Yeah. We really are going to stay very focused on the three private pay segments. We like that strategy. It keeps us clearly in the real estate game serving the healthcare industry. We're not believers in the bumpy ride of government reimbursement. That doesn't mean that's not a good strategy for another company. It's just not the one that we've selected here at HCP.
Okay. Thanks. And, Scott, congrats on getting back in the saddle.
Thank you.
Okay. The next question comes from Sheila McGrath with Evercore. Please go ahead.
Yes. Good morning. On the transition assets in SHOP, is it your expectation that first quarter was a low point? And what are the new operators doing differently to help ramp NOI? Is it required additional cutbacks, rebranding, what are they doing to reposition those?
Hi, Sheila. It's Scott Brinker. 1Q 2018 should be the low point in part because of what's been described earlier where we really had a decline in performance throughout 2017. So, whenever you're looking at a growth rate, you need to understand the beginning and the end. And, at least for 1Q, we had a very difficult comparable. So, simply because of the difficulty of the comp in 1Q, that should be the worst quarter.
But in terms of what will change, one is just an attention to the property. I think there was some distraction at a number of these assets over the past three years. When we look at performance in the markets versus performance of our property in particular, there's a pretty wide gap. Now, there are some properties that we consider to have great real estate locations but may be older physical plants and there could be a redevelopment opportunity. And we're actively looking at a number of those right now and those could come sooner rather than later.
And the other thing I would mention is, for the most part, we weren't satisfied with the management teams at the local communities. So the expectation is that there will be a fair amount of transition at the key leadership positions. And unfortunately, that creates under-performance in the near-term, which for a public company isn't ideal, but we made the decision that these were good properties. And over time, we're confident with the right local teams and the right operating company up top that we will recapture anything that's lost in that sum.
Thanks. And one follow-up on the balance sheet. You've targeted moving leverage lower. Pete, can you just remind us of your targets and the timeframe and how you got there?
Yeah. Hey, Sheila. It's Pete. So, on a pro forma basis, we're at 6.5 times. We were able to pay down some of the line post the quarter-end. We'd like to be in the low-6s by the year-end. We're on track for that based on our projections for these sales. We'll probably be able to get there depending on the timing of the sales, in the third quarter would be the assumption. But, again, that depends upon the closing of some of these transactions, which in senior housing can sometimes take some time but definitely by the end of the year.
Okay. Thank you.
Thank you, Sheila.
The next question comes from Chad Vanacore with Stifel. Please go ahead.
Good morning, all, and welcome aboard, Scott.
Hey, Chad.
Hey. So, given the amount of dispositions expected mid-year, consensus seems to forecast FFO progression should be down in second quarter, another dip in third quarter and then flat in the fourth quarter as some of those proceeds maybe are reinvested. So, does that agree with your internal models? And then what factors should we be considering in terms of disposition, timing and use of proceeds?
Yeah. Hey, Chad. Let me start with the first part of that question. As I said in my prepared remarks, the first quarter benefited from some higher yielding assets. We've now sold some of those post quarter-end. So, as we look at our progression through the year, we see the first quarter being the highest, the second quarter probably being slightly higher as well as we work our way through some of these transactions.
And then, based on the timing, if you look at our guidance page that we have in the supp, we would see the third and fourth quarter numbers probably being a good run rate going forward. But then, you have to factor in, in 2019, which we're obviously not coming out with guidance yet, some of the benefits of lease escalators, developments coming on line. In life sciences, as we re-lease, we see some positive leasing spread that's pretty significant as well.
So, that's how we look at 2019 at a high level, but the rest to 2018 sort of lines out as I just described.
All right. Pete, maybe last quarter we probably talked about $0.07 to $0.10 per share net dilution. Is it still a good range or should we be thinking about something else?
Yeah. I think that the net dilution as we think about the benefits we're getting this year in our numbers, it's probably around $0.05 a share of the benefit we have in 2018 that will have some dilution as we head into 2019, but offsetting that with some of the benefits that I just described.
Got it. Okay. And then, just one more on SHOP performance. Most of the worst performance was in that portfolio held for sale. And then, Tom, in your comments, you actually alluded to seeing some pressures in those communities in terms of management. Maybe give us some additional details on the changes at the facility level and then how might they be stabilized under new operators.
Yeah. Chad, if you could maybe repeat the question, just to clarify exactly what you were asking. I got a little bit confused. Please.
Okay. So the SHOP performance or the SHOP portfolio that's either held for sale or going to be transitioned, on the transitional assets, how might they be improved from where they are now?
I see. Thank you. Well, important to note that these were historically strong performers with occupancies in the low-90s. And today we're in the mid- to low-80s. And these are markets that are otherwise performing reasonably well. So we think with the right leadership teams at the local communities, there's an opportunity to recapture what's been lost, Chad.
That doesn't happen overnight. We've identified 30-plus transition communities in 2014. We've successfully finished the transition, but that's fairly recent within the last 30 days. We think the balance of the transition should be done in the next two months or so. So, by year-end, we think we'll be completely through the transition process, and the new operators will be up and running with their own teams and systems. But it doesn't happen overnight.
So, Scott, maybe where might be some of the low-hanging fruit? Is it on G&A, or is it more operationally focused in flavour?
Yes. Chad, it's more having the right team at the local community. I mean, when you think about what drives performance, there's the real estate aspect. And again, we like the real estate of these properties, but then there's the local culture within the property.
And we spent a lot of time touring all these communities to get a sense for what was it that was driving the underperformance, and we came away with comfort that, over time, this is real estate that should perform but we have local teams that are not executing. And that will be the emphasis of the new operator is, of course, putting in their own systems and technology, but putting the right leadership teams in place to drive performance.
All right. Thanks for taking the questions.
Okay. The next question comes from Tayo Okusanya with Jefferies. Please go ahead.
Hi. Yes. Good afternoon. Most of my questions have been answered, but just another one for the team. Going back to Vikram's question, not specifically around the Welltower transaction. But, again, when you do look out in the horizon, are opportunities to kind of do deals where you're restructuring problem assets, where you think you can see upside on a going-forward basis because you expect fundamentals to improve in two to three to four years?
What's kind of like the appetite for the management team to kind of do deals like that? And what kind of structures would you consider putting in place if you were to consider doing something like that?
I'll start and then I'll turn it – this is Herzog. I'll turn it to Scott. But I can tell you that, as we look at our portfolio, we do identify different opportunities as we go forward where there could be restructuring that takes place that provide better outcome over time. And there are a variety of different alternatives that we do discuss, that we're assessing. Nothing we'd be ready to announce at this point, of course. But as to our appetite or desire and ability to take these on, the answer to all of those is that, yes, those are things that we're interested in doing.
And, Scott, is there anything you'd add from your perspective?
I would just say our, I think, biggest opportunity right now is the value creation in the existing senior housing portfolio. So, that's been occupying a lot of our time and that's a pretty big project that I think when we're done, will create some value for shareholders. It's creating some short-term noise in our operating results, but I think people over time are going to like the outcome. There is some more work to be done, but it will be around the edges as opposed to the very material news that's been announced over the past year.
And our other two segments, our life science and medical office, and frankly, there's not much distress in those two segments. If there was, we'd be all over it given the strength of our teams.
Got you. Okay. That's helpful. No more from me, Scott. Again, good to kind of have you back on board. And to the HCP team, I think Kent Griffin is a great get.
Oh, thank you.
Okay. Thank you. The next question comes from Drew Babin with Baird.
Hey. Good morning.
Hey, Drew.
Quick question on the for-sale portion of the SHOP portfolio. Do you believe there's any risk that kind of culturally or otherwise fundamentals? And I guess how confident are you that fundamentals can hang on at those properties long enough to realize the potential sale pricing that's been talked about before? Do you think there's any risk that things might deteriorate to the point where a buyer may begin to consider things they may need to do to get operations going again?
Hey, Drew. It's Scott here. What we'd say is there's significant interest in the assets. And everyone that we've spoken to is bringing in their own operating partner and underwriting their own business plan. The performance at those properties is already pretty weak and I don't think a small decline over the next two months is going to materially change the valuation.
Now, is it a positive? No, of course not. But I don't think it's materially changing the dynamics. It just puts us in a position where we like to get something done sooner than later and we're making good progress. So we hope to have more significant and specific news in coming months.
Yeah. This is Herzog again. The other thing I'd add is, in talking to buyers, there is a view that there is upside potential in these assets as the transitioned as well. And so, that factors into the thinking in underwriting. So the fact that the assets have stumbled from a same-store performance perspective causes buyers to believe there could be some upside as well.
Thanks. That helps. And just one question on life science. Do you think current same-store occupancy levels, 94.3%, do you think that represents a bit of a bottoming? Or do you think the downtime required to sustain the robust leasing spreads on new activity, do you think that downtime is going to kind of keep that occupancy level kind of roughly where it is through next year?
No. Drew, it's a good question. Actually, the occupancy drop, and we've actually backfilled all those leases already. They just haven't started this quarter. They will start some in the second and I think maybe one towards the third quarter. But we're getting good leasing spread and we backfilled that. So we see occupancy ramping up as the year progresses there.
Good to hear. That's all for me. Thank you.
Thanks, Drew.
This concludes the question-and-answer session. I would like to turn the conference back over to Tom Herzog for any closing remarks.
Okay. Thank you, operator. And thank you, everybody, for your time today and your continued interest in HCP. We look forward to talking to you soon and we'll see some of you at Nareit. Thank you.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.