Physicians Realty Trust

Greetings and welcome to the Physicians Realty Trust first quarter 2022 earnings conference call. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during a conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Bradley Page, Senior Vice President, General Counsel. Thank you. You may begin.

Thank you, Doug. Good morning and welcome to the Physicians Realty Trust first quarter 2022 earnings conference call and webcast. Joining me today are John Thomas, Chief Executive Officer, Jeff Tyler, Chief Financial Officer, Deanie Taylor, Chief Investment Officer, Mark Thine, Executive Vice President, Asset Management, John Lucey, Chief Accounting and Administrative Officer, Lori Becker, Senior Vice President, Controller, and Amy Hall, Senior Vice President, Leasing and Physician Strategy. During this call, John Thomas will provide a summary of the company's activities and performance for the first quarter of 2022 and year to date, as well as our strategic focus for the remainder of 2022. Jeff Tyler will review our financial results for the first quarter of 2022. Mark Fine will provide a summary of our operations for the first quarter. And finally, Amy Hall will provide a summary of our leasing activity for the first quarter of 2022 and our thoughts about the market for the remainder of the year. Following that, we will open the call for questions. Today's 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 affected 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 are implied in such forward-looking statements. For a more detailed description of potential risks and other important 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.

Positions for Realty Trust is off to a strong start to 2022. Our operating platform continues to perform exceptionally well with operating cash flow at peak levels and occupancy near all-time highs at 95.2%. Despite interest rates that have accelerated at an unprecedented pace, Seller expectations on cap rates have barely budged, if at all, limiting quarterly investments to $23 million as we maintain discipline in deploying capital in this volatile capital market. The DOC portfolio was built with a focus on the long term. Our shareholders benefit in the short term from actual cash flow and long term from disciplined accretive growth in both assets and cash flow. And like other sectors, the DOC portfolio remains full, near full occupancy And our headline growth rates are not the result of cash flow lost during the pandemic. Our buildings have remained full and performing, generating authentic growth through a focus on net effective rent, financing accretive development of medical office facilities, and selective external accretive acquisitions. Historically, growth in medical office rental rates have been generally limited to 2% to 3%, both in annual lease rate increasers and renewal spreads. Any growth in excess of this range has typically required excessive incentive packages that have served to increase headline rents at the expense of net effective rent, actually reducing total cash flow. We have and continue to resist the temptation to embrace short-term measures that improve quarterly statistics at the expense of long-term growth and firmly believe that this is the right approach that best benefits our shareholders. That's why I'm excited to share that we see, for the first time in my 20 years of experience in medical office, the opportunity to organically grow lease-level cash flows by more than 3%. Amy Hall, our Senior Vice President of Leasing and Position Strategy, will share more information in a few minutes about our experience here today and our expectations moving forward. DOT's pipeline to finance development is deeper than ever. Our strategy for development has been to align our interests with third-party developers and health systems by financing projects directly at a cost that allows for initial rents that are in line with market while providing our shareholders with accretive returns. These accretive returns come initially in the form of the development yield, but later in the form of an attractive purchase option. It is a deliberate decision that we don't self-perform development, as we don't want to compete with the many great developers that we partner with to serve our health system and position clients. This also benefits our shareholders as we avoid the significant G&A cost of a development team that would be both cyclical and redundant with the skills of our clients. On our last call, we forecasted $250 to $500 million of new investments in 2022, inclusive of stabilized acquisitions and new development. As of today, we estimate we will have the opportunity to finance projects that will cost approximately $160 million to build and will have value in excess of $200 million once online in 2023 and 2024. The pipeline is highlighted by pre-leased health system-anchored medical office facilities and ambulatory surgical suites in fast-growing top 20 MSAs. While construction costs are inflating, our projects are financed on a yield-on-cost basis that is higher than acquisition cap rates with a GMP construction contract in place. Development momentum remains strong in today's rate environment as providers understand that they need more outpatient surgical and diagnostic facilities outside of the four walls of the inpatient hospital. This is appropriate clinically as it moves care to the lowest cost setting while preserving precious hospital resources for the treatment of infectious disease and provision of high-acuity services. Outside of development, our investment philosophy remains focused on best-in-class facilities where we can add value through superior customer service that drives retention and cash flow growth. Cap rates on stabilized properties have compressed each year since 2013, but it's our view that the compression is most seen in older Class C properties. Accordingly, our investments, beginning with the acquisition of the CHI portfolio in 2016, have focused on higher-quality facilities They may be more expensive on a nominal basis, but are expected to provide the best risk-adjusted IRRs over the long term. Each of our investments are made based on the expectation that a property will benefit not from further cap rate compression, but from its long-term strategic value to the healthcare providers. While there's a high volume of Class B and C assets available to acquire in the market, we don't believe that they carry enough yield relative to the Class A assets we're targeting to offset the risk an owner takes in today's environment. Instead, we will remain disciplined and selective, pursuing investments where we can match our long-term objectives with those of the healthcare providers occupying those assets. This focus on high-quality assets includes the environmental impact of our investments. We continue to be excited about the results we have achieved on our environmental three-year goals established in 2019 that matured in 2021. That is just a start, and we'll report those results formally and transparently in our third annual ESG report to be released in June 2022. As we will share then, we are increasing our commitment in all areas to reduce greenhouse emissions, that the environmental impact of our buildings for the improvement of the communities we serve, and remain on target to achieve our goal of reducing greenhouse gas emissions by 40% in 2030. We also believe that evidence shows that investments will generate stronger retention, higher rental rates, lower occupancy costs, while producing better cash flow and long-term value for our shareholders. I'm proud to share that Physicians Realty Trust is honored to once again be recognized by the Milwaukee Journal Sentinel as a top workplace for the fifth consecutive year. Top workplaces are determined through an annual team member survey collecting data on company leadership, compensation, and work environments. Congratulations to the entire DOC team on building and maintaining our unique company culture that continues to be recognized among the best in both Milwaukee and our industry. Study after study shows that companies with a focus on culture deliver superior total shareholder return over the long term. We will not sacrifice our commitment to culture for short-term financial benefit. We're also proud to share that our Senior Vice President of Physician and Leasing Strategy, Amy Hall, has been selected as a 2022 Globe Street woman of influence. This award shines a light on individuals that have personally impacted the market and significantly driven the industry to new heights via their outstanding success across commercial real estate. Thank you, Amy. We completed our annual shareholder meeting yesterday, and I'm proud to report we had 95% or greater approval for each of our trustees and for our executive compensation plan. We work for our shareholders, and while others are distracted in trying to restore the trust of their shareholders, We have the trust and are able to focus on working with our outstanding physician clients, health system partners, and developers delivering long-term returns for our shareholders. We appreciate our loyal shareholders who recognize us for our discipline and strategy for long-term growth, and we welcome new investors as they, too, recognize the strength and stability of our trusted platform. I'll now ask Jeff Tyler to share our financial results. Mark Thine will then share our operating results, and Amy Hall, who will report on the current leasing environment.

Jeff. Thank you, John. In the first quarter of 2022, the company generated normalized funds from operations of $63.4 million, or $0.27 per share. Our normalized funds available for distribution were $61.5 million, an increase of 13% over the comparable quarter of last year, and our FAD per share was $0.26. Portfolio performance was steady this quarter, generating same-store NOI growth of 2%. Importantly, the landmark portfolio has been successfully integrated and is performing at our underwritten expectations. Across the portfolio, we are seeing continued strength in the operations of our tenants, both in the reported financials and insurance claim volumes that we monitor on a near real-time basis. Based on the carefully curated portfolio we've built over the past nine years, we believe we are well positioned for long-term success no matter what happens in the macro environment. Speaking of the macro environment, as everyone knows, we are already seeing data that reflects the highest inflation in 40 years. Our portfolio is built to withstand destructive force. We've always concentrated on providing predictable and secure cash flow to our investors by embedding expense recovery provisions within 98% of our leases to pass on those inflationary costs to the tenant. We also maintain the highest occupancy in the sector, which minimizes the cost leakage of those expenses to vacancy. Combined, these attributes result in a landlord expense protection ratio of 93%, which is unparalleled and provides certainty of income for our shareholders. Moving forward, as market participants consider the negative GDP print of minus 1.4% for the first quarter, there has been increasing concern about the durability of the economic recovery. We don't profess to know exactly what the future holds for the U.S. economy, but we are certainly comforted by what we do know. 64% of our rental income is derived from investment grade quality entities or their direct subsidiaries. As we saw over the course of COVID, when we collected over 99% of our rent and put just one single tenant on a short-term deferral, we believe that our rental income is safe no matter what happens. Exceptional tenants lead to exceptional stability. That same theme rings true on the capital side. We were able to raise $500 million in October of last year at a rate of 2.625%, using 250 million of that to pay off our term loan that was due to mature in 2023, eliminating our one significant near-term funding risk. Our balance sheet overall is in great shape. Our consolidated leverage at 5.65 times debt to EBITDA will be substantially below our single MOB peer, assuming their merger passes the shareholder votes. In summary, Our company remains on solid financial footing and is poised to perform well in any environment. With that, I'll turn it over to Mark.

Thanks, Jeff. I'm once again pleased to highlight the value of our asset management, leasing, and capital projects teams who delivered another solid and consistent quarter. Our relationship-driven platform and culture cannot be easily replicated in today's labor market, and our investors significantly benefit from the concentrations and knowledge that we have developed in our top markets across the country. From a performance perspective, our MOB same-store NOI growth in the first quarter was 2.0%. The NOI growth was driven primarily by a year-over-year 2.6% increase in base rental revenue and operating expense recoveries, as our net lease structure served to protect our investors in this inflationary environment. Our focus on landlord expense protection is best shown in our sequential same-store results where operating expense recoveries grew 9.8% and offset the 8.5% increase in operating expenses observed relative to the prior quarter. Sequentially, same-store portfolio occupancy remained flat at 95%. However, we are optimistic that the occupancy in the same-store pool will grow in the second half of the year as we currently have 15 leases totaling 49,000 square feet that are under construction, have not commenced, and are not yet included in our occupancy statistics. Had those leases been in place and paying rent throughout the quarter, annual same-store growth would have been upwards of 2.4%. Turning to CapEx, our capital projects team efficiently completed FAD CapEx investments of $5.7 million, representing 6.2% of cash NOI. Embedded within all capital investments made by DOC, is a strong commitment to the materials and practices that enhance the patient experience, as well as our ESG green-to-green philosophy. These efforts continue to be independently recognized, with DOC proudly earning 10 new property-level ENERGY STAR certificates in 2021, as well as 10 new certified sustainable property designations from the Institute of Real Estate Management. Over the last three years, DOC has earned a total of 28 certified sustainable property designations and reduced our energy usage and greenhouse gas emissions by over 10%, continuing our record of recognition for leading sustainability initiatives. We look forward to continuing the sustainability conversation in June following the release of our third annual ESG report. The narrative on medical office has long been focused on the predictability and safety of the underlying cash flows. And we firmly believe that the DOC portfolio is positioned to deliver outsized internal growth in the quarters and years to come through the efforts of our talented and determined operating teams. Joining us today to share more about the leasing trends we're seeing in today's medical office market is our Senior Vice President of Leasing and Physician Strategy, Amy Hall. Amy?

Thanks, Mark. It's a pleasure to join the team on the call today. Prior to joining DOC in 2016, I worked in the leasing industry for over 10 years at CBRE and Cushman Wakefield, serving CHI, which is now Common Spirit, as one of my main clients. That experience helps me and Doc execute a balanced leasing strategy, maximizing value for our shareholders, and remaining aware of the priorities of our health system tenants to achieve the best long-term outcomes for both parties. Before we dive into some quarterly results, it is important to remember that prospective leasing conversations often begin as early as six to 12 months before commencement. While the first quarter leasing results were reasonably good, they were realized without the full benefit of recent inflation that has increased costs across the board, including the cost of new MOB construction by more than 20% in the last year alone. We will really start to see the impacts of those changes with higher releasing spreads in Q2 and beyond. During the first quarter, our leasing team completed 209,000 square feet of lease renewals on the consolidated portfolio at an aggregate re-leasing spread of 2.1%, consistent with historical trends of 2% to 3%. Excluding the impact of a 5,000 square foot tenant that we strategically retained at a lower rate in order to preserve the cohesive ecosystem of a multi-tenant property, re-leasing spreads for the quarter were above 3%. We also kept TI's low at $1.28 per square foot per year, well below industry averages as we continue to focus on net effective rent as the most important measure of total leasing performance. Tenant retention for the quarter was 76%, mostly in line with our 80% to 85% target with portfolio absorption remaining effectively flat. Our strong overall absorption and occupancy rates continue to provide confidence that we can selectively vacate certain suites and find higher rental potential with different tenants. New lease TIs total $2.01 per foot per year as tenants opted to contribute more of their own capital toward tenant finish to reduce the growth in real rate in this landlord-friendly environment. Demand for medical office remains robust, both off campus and on, as health systems and physicians work to position their outpatient real estate footprints to best serve their patients. This demand, backstopped with inflation that increases the value of our existing medical office assets, gives us confidence that leasing economics will continue to accelerate throughout the remainder of 2022 and in the years to come. We expect leasing spreads for the second quarter to be in the mid to potentially even high single digits. We are also negotiating leases that lend visibility to third and fourth quarters, where we expect renewal spreads to be in the mid single digits. Alongside these higher than expected spreads, we're finding success in increasing tenant rent escalators to be better aligned with today's inflationary environment. For example, current market conditions allowed our team to increase the annual rent escalators for a major health system lease from 2% to 5%. In fact, of the 53 renewals completed during the first quarter, 11 had an escalator that was greater than prior in-place measures. Escalators on new leases averaged 2.7% in the quarter, meaningfully ahead of our 2.4% portfolio average, and we expect to continue to find success on this front moving forward. This is especially true in our urban markets like Atlanta and Phoenix, where market escalators are now approaching 4%. These trends indicate a structural shift in the MOB market, and barring unforeseen circumstances, we expect them to continue in the years ahead. We believe our portfolio is well below market rates overall and see our upcoming lease role in this environment as an opportunity rather than a risk. Put simply, Doc's medical office portfolio is poised to capture the benefits of this inflationary environment. With that, I will hand it back over to JT.

Thank you, Amy. Doug, we're now happy to take questions.

Thank you. Ladies and gentlemen, at this time, we will be conducting a question and answer session. If you'd like to ask your question, you may press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Nick Joseph with Citi. Please proceed with your question.

Hey, this is Michael Griffin on for Nick. Wanted to touch on external growth at first. Curious what you think of the expectation for the cadence of investments to trend throughout the remainder of the year relative to initial guidance.

Yeah, I think we're, again, we're off to a little bit of a slow start. And again, most of that's more attributable to kind of the volatility of the capital markets, interest rates in particular, versus, you know, kind of opportunities that we see in our investment pipeline. So I think we're still on track for the year to do 250 to 500 million total. That does include the development financing, which of course is kind of, you know, will be more back-ended because of those projects just get started this summer and you're spending as the construction process evolves. But again, I think there's plenty of good opportunities for us in the acquisition market as well, but it'll be limited this year and more in the second half than the first half just due to the capital markets in particular.

Right. And JT, you touched on cap rates relative to rising interest rates in your prepared remarks, but I'm curious, obviously with the expectations that interest rates are going to continue to increase for the near foreseeable future, do you see an anticipated upward pressure in cap rates maybe in the near to medium term?

You would expect it, but we haven't seen it. And I think that comes from just the flood of capital chasing the medical office product. There's a lot of Class B and Class C assets out in the market right now and that are trading in the low fives. And those rates haven't really changed other than compressed since last year. So we'll see how it goes. That's part of the reason why we're being patient and looking more to investments, if at all, in the second half of the year. But we anticipate making those investments. Great. That's it for me. Thanks for the time. Yep. Thanks.

Our next question comes from the line of I'm Mateo Axuriana with Credit Suisse. Please proceed with your question.

Yes. Good morning, everyone. So in latter part of 2021 with the same store numbers, again, kind of more at the higher end of that 2% to 3% range, I've done a really good job with kind of operating expense management. This quarter, it looks like OPEX kind of ticked up quite a bit. I'm wondering if you could talk a little bit about that and the negative impact it had on your same store NOI number?

Hey, Kyle. Yeah, this is Mark on the operating expense side for same store. The fourth quarter and first quarter are both a little bit higher than what we typically see in our operating expenses. This quarter, they're up about 4%. That's primarily driven by utilities and janitorial. And, uh, and then sequentially, you know, utility rates have been, have been increasing a little bit. Um, and then in, in the first part of this year, we also reset our annual, uh, real estate tax and insurance accruals. So those, those are a bit higher for the year, but you know, the beauty and the strength of the doc portfolio is that, uh, we're 95% least and primarily all triple net least. So we talked about our landlord expense protection, uh, and, uh, and you know, those costs are passing back to the tenants. so um you know we're working hard as an asset management team to operate all the buildings efficiently and cost effectively and uh in utilizing our scale especially in markets where we have good concentration to manage those operating expenses uh and we think that through some of the capex investments we're making uh we'll be able to lower some of those utility costs in the back half of the year but uh again we're optimistic about same store in the back half of the year as a result of uh of some of the leasing efforts and i think that uh in the back half of the year, you know, we'll be back up above our annual average rent escalator from some of the occupancy that's under construction and we'll be coming online.

That's helpful. And then also, if I may ask one more question on the retention side, again, the target has historically been 80 to 85, you know, very close to it this quarter, but they got to do it like 79 or so. Last quarter was like 76. Just kind of curious what, again, what's happening on that end as well, because the last few quarters, you have had negative kind of net absorption in the portfolio, both in 4Q and 1Q.

Yeah, Ty, it was JT. You know, if you have four leases to renew and you renew three of them, that's 75%, right? So it's really more a function of that than, you know, over the course of time, it's 80% to 85%. But, you know, quarter by quarter just depends upon how many leases you have and, you know, what the square foot is. So there's no downward or negative trend there. It's just a function of our highly leased occupancy.

Gotcha. Okay. That's helpful. Thank you.

Our next question comes from the line of Austin Warschmidt with KeyBank. Please proceed with your question.

Great. Thanks, and good morning, everyone. JT, given the comments you made on cap rates and, you know, thinking that, you know, you would expect upward pressure but haven't seen it, and where the stock's trading today, I mean, did dispositions become more attractive funding source you know, to fund sort of the investment activity for the year?

Yeah, Austin, and welcome to the team. You know, that's something where it's a great, it's a seller's market. It's a great, you know, time for dispositions. We don't have a lot that we really are interested in selling, but we expect some opportunistic dispositions this year, you know, kind of capturing these you know, these strong cap rates, you know, per asset. So I think you'll see some dispositions during the year, but it won't be a huge number. And we really like our portfolio overall.

Got it. And then I'm just curious, since you've closed the landmark portfolio, I think you had some new relationships that came from that. Have you seen any pickup in the investment pipeline around those new tenant relationships?

Yeah, it's a little early for specific contracts or leasing. I mean, we've got a great start on the leasing contract. as well but the uh edini was at a function with one of those health systems the other day talking about their own investments in the building we bought plus the opportunity for expansion of an additional twin building in that portfolio so we we really anticipate over time a lot of great uh add-on opportunities with those health systems great thanks for the time you're welcome our next question comes from the line of richard hill with morgan stanley please proceed with your question

Hey guys, good morning. This is Adam Kramer on for Richard. Wanted to ask a little bit more in detail about kind of the acquisitions. I recognize you're kind of maintaining this $250 to $500 million kind of total investment activity guide. Wondering if you could kind of give a split between acquisitions or external growth through acquisitions versus kind of the investments that you guys talked about. And then any kind of further, I guess, kind of commentary on the investments would be helpful as well.

So I think, you know, it's hard to predict an accurate split today, but, you know, probably 50-50 would be, you know, a reasonable assumption between development starts and acquisitions. I think we'll clearly get to 50% on the development pipeline side of that number and probably have some more opportunities there that we might close in the third and fourth quarter. So probably, you know, a little bit of a lean toward the development to get to the higher end of that range. But, you know, we've already, we completed subsequent to quarter end a $27 million acquisition, which is adjacent to one of our other medical office buildings, very synergistic in that new Albany market with a great health system and, frankly, a building that Mark Dynan and I have been chasing for 10 years. Again, it's adjacent to a building that took us eight years to acquire, so we're persistent and consistent. I think the acquisition environment is fine. I think there's some good opportunities out there. We're just being very careful and selective in this capital market.

Yeah, no, that all makes sense. I guess, look, this has been touched on a few times already, so I apologize. I'm kind of beating a dead horse. But I also just want to kind of ask about, you know, kind of whether I guess kind of the guide is, you know, kind of implies a step up in acquisitions, you know, kind of the latter part of the year, right, when cap rates may have kind of widened already, right? And you kind of mentioned already that the cap rates may not have moved yet. And so wondering if kind of the guide just kind of allows you to maybe capture greater acquisition volumes later in the year when cap rates will have, you know, kind of widened?

Yeah, I think your point is exactly what we're thinking, which is, you know, those assets that, again, almost all of our business is off market. And so, you know, it's really a kind of ebb and flow in the negotiation, you know, trying to match fund with our capital and our cost of capital with the acquisition cap rate. So, I mean, certainly there can be more opportunities later in the year, particularly if cap rates do ease back a little bit, and then, you know, investment activity might accelerate.

That's really helpful, guys. Thanks again, and we'll chat later on. Appreciate it. Yep.

Thank you. Our next question comes from the line of Juan Cenebria with BMO Capital Markets. Please proceed with your question.

Hi. This is Valeria. I'm for Juan. About funding, how should we think about your acquisition pipeline if we shouldn't expect, you know, a large uptick in dispositions?

Yeah, this is Jeff. I'll kind of cover that. So, certainly, as we think about funding, and J.A.T. mentioned it earlier, there could be some opportunistic dispositions as, you know, there's been a lot of interest in various buildings in our portfolio, so we evaluate those, of course. You know, putting that aside, when we evaluate these acquisitions, we're always making sure that from a cost of capital standpoint, it's advantageous to our shareholders to acquire them. So we look at, you know, what our cost of long-term debt is and what our cost of equity is and make the determination based on that. You know, I think that's a big part of the reason when we talk about the split of acquisitions, you know, a lot of that split is more of that split this year is dedicated towards developments and loan funding, that kind of thing.

Okay, gotcha. And one more question. So recognizing that you raised shares via the ATM, what's your view of selling assets to buy back stock in a leveraged neutral manner with the implied cap rate of 5.8, which is what we have?

Yeah, you know, it depends. So certainly, to the extent we have assets that we don't think are good long-term holds, that is something we've done, right? And we did that back in 2018 when we did a portfolio and sold assets and took down leverage. You know, mathematically, it isn't really that effective when our share price is where it is to sell assets and buy back stock because you lose a lot of that benefit just with the deleveraging alone. You know, it's a good theoretical exercise, but you generally need a stock price that's pretty significantly lower than it is now.

Yeah, for the long term, I think, you know, the dispositions we might achieve this year, we think we'll be at cap rates where we can be accretive in new investments that improve the portfolio and improve the yield that we're getting on the assets we're selling. So we think that's a better long-term, you know, use of that capital.

Okay, great. Thanks. That's it for me.

Doug, I think that's it for the questions. Thanks, everybody. There are no other questions. Thanks, Doug. We look forward to seeing everybody at BOMA, and they may read in a couple of weeks, and thanks for participating today.

Ladies and gentlemen, this does include today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.