2023-08-22 05:39:17 ET
Summary
- Healthcare Realty Trust Inc. trades at a five-year low based on implied cap rate.
- HR shareholders could see outsized returns in a year on the back of multiple catalysts.
- Shares are currently trading at significant discounts to both fair value and the broader market.
Summary
- HR currently trades at a 7.2% implied cap rate, which is the lowest valuation in the last five years, which includes its COVID valuation (2Q20 implied cap rate was 5.8%).
- HR shareholders are poised to see a total return in excess of 24% over the next twelve months through a combination of accretion upside from the acquisition of Healthcare Trust of America (HTA) , accelerating internal growth, and a low-risk dividend.
- -26.0% relative share price performance vs. the Vanguard Real Estate Index Fund ( VNQ ) over the past year, leaves HR’s gross assets trading at a -40% discount to its replacement cost and its shares trading at a -22% discount to its intrinsic Discounted Cash Flow ((DCF)) value despite occupying one of the lowest risk real estate asset classes with ample secular and demographic tailwinds behind it.
Investment Recommendation
I recommend a BUY rating for Healthcare Realty Trust Incorporated (NYSE: HR) with a price target of $20, representing a 24.6% total return over the next twelve months. Furthermore, I also believe HR shareholders are poised to see ~16% low-risk total returns for the foreseeable future through a combination of: (1) dividends, (2) low-risk internal growth, and (3) capital light accretive ventures (e.g. Joint Ventures).
Near term, catalysts for the stock include near-term earnings dilution from the acquisition of Healthcare Trust of America (NYSE: HTA) converts into long term earnings accretion and (2) a shifting SOFR (i.e. Secured Overnight Financing Rate) curve leads to unanticipated earnings upside.
HR has underperformed VNQ by -26.0% over the past year as impatient investors have penalized HR for short term earnings dilution related to its acquisition of HTA. I estimate that HR’s gross real estate assets are trading at a -40% discount to its replacement cost and its shares are currently trading at a -22% discount to its intrinsic DCF value despite occupying one of the lowest risk real estate asset classes with ample secular and demographic tailwinds behind it.
Potential Catalysts
- HR shares trade at an implied cap rate that is more appropriate given current interest rate levels (positive).
- Running a regression over the last five years indicates that if 10-year US Treasury yields remain at their current level of 4.26%, HR shares should trade at a 6.6% implied cap rate instead of its current 7.2% implied cap rate.
- Proceeds from expected asset disposition surprise to the upside given commentary that cap rates have recently tightened despite interest rates remaining elevated (positive).
- Earnings guidance and accretion guidance from the acquisition of HTA surprise to the upside (positive).
- Healthcare labor inflation remains stubbornly high causing Same-Store (SS) NOI margins to tighten and SS NOI growth to surprise to the downside (negative).
- HR reported labor expense growth of +10% y/y in 2Q23, down from almost +14% in 1Q23, but still above average.
- The Federal Reserve continues to raise rates resulting in increased interest expense to HR given 15% of its debt is variable-rate after accounting for interest rate swaps (negative).
Company Background
Healthcare Realty Trust Inc is a fully integrated Real Estate Investment Trust ((REIT)) that was founded in 1993 with an initial portfolio of 21 healthcare facilities. Over the years, the company has refined its portfolio primarily towards multi-tenant, on-campus medical office buildings. In July of 2022, HR merged with its larger peer HTA, resulting in a portfolio of 714 properties (42 million SF) in 35 states, representing the largest portfolio of medical office buildings that is owned by a publicly traded REIT.
The Impact of the HTA Acquisition is Not in the Rearview Mirror
Healthcare Realty closed its acquisition of Healthcare Trust of America (HTA) on July, 20, 2022 , resulting in HR’s size more than doubling in terms of square footage. While many REIT investors have a preference for viewing REITs in terms of Net Asset Value ((NAV)) per share, given the dearth of transaction volume in private real estate markets, I think it makes more sense to view HR’s valuation in terms of implied cap rate relative to interest rates.
As of 2Q22 (the last full quarter of legacy HR) HR’s shares were trading at $27.20, implying a cap rate of 6.0%. As of 2Q23 (one year later) HR’s shares were trading at $18.86 (a -31% decline in share price y/y), implying a cap rate of 6.8%. In order to bifurcate what percentage of HR’s share price decline was due to a change in implied cap rate (valuation) vs. asset/NOI performance, I applied the same 6.0% 2Q22 cap rate to HR’s 2Q23 line items to keep the comparison apples-to-apples, which yielded an equity value of $23.22 (a decline of -15%).
Google Finance, Company data, Analyst estimates.
Although HR’s annualized NOI increased +126% between 2Q22 and 2Q23, the fact that HR’s per share equity value decreased by -15% (after controlling for changes in implied cap rate) would indicate that the HTA acquisition has thus far been dilutive on a per share basis.
Google Finance, Company data, Analyst estimates.
HR management indicated on its 1Q23 earnings call th at it takes 3-5 years to really see the full benefit of an acquisition of this size. Given the sheer size of the acquisition (more than doubling the size of the company), I think realizing the benefits of an acquisition of this magnitude in less than 12 months is an unrealistic expectation. Why many investors may think that the HTA acquisition is in the rearview mirror given that it was closed more than a year ago, I think the benefits of the acquisition are very much still in front of us. On HR’s 2Q23 earnings calls , management mentioned that while they expect SS NOI growth of 2-3% in 2023, they see a clear path to SS NOI growth of 4-6% and FFO/share growth of 5-7% in 2024.
On HR ’s 4Q22 earnings call , management mentioned that they had fully transitioned the legacy HTA portfolio to their leasing model, and that the largest opportunity for occupancy gains lies in legacy HTA’s portfolio which has an occupancy that is 400bps below pre-COVID levels. Given that legacy HR’s portfolio had an occupancy 100bps higher than legacy HTA before the pandemic, the total opportunity of having legacy HTA’s portfolio on HR’s leasing model could be as high as +500bps of upside to occupancy.
Assuming legacy HTA’s portfolio consists of ~$500mn of cash NOI and assuming a 65% NOI margin, I estimate that the upside in terms of NOI from leasing up the legacy HTA portfolio is ~$29mn, which should be organic and require no additional capital.
Company data.
Running a regression between 10-year US Treasury yields and HR’s implied cap rate over the past five years yields an R-squared of 0.53. Inputting the current US Treasury yield of 4.26% into the regression X-coefficient generates a predicted implied cap rate of 6.6% vs. a current implied cap rate of 7.2% (based on a share price of $17.05). The current residual (i.e. the actual value less the predicted value) of +65bps is the highest residual that HR shares have traded at since 1Q20 when HR’s shares traded at a residual of +68bps (HR was trading at a 5.9% cap rate when the 10-year Treasury yield of 0.7% would predict an implied cap rate of 5.3%).
Google Finance, Company data.
Adding the NOI upside and using the predicted implied cap rate of 6.6% (from the regression), implies a share price of $21.15, representing an upside of +24.1% from HR’s current share price of $17.05.
Google Finance, Company data, Analyst estimates.
Medical Office is Not the Same as Traditional CBD Office
The headwinds against the New York office market have been both plentiful and well publicized. Starting in 2018, the $10,000 cap on the state and local tax income deduction hurt New York’s competitiveness. The following year, NYC’s largest office tenant (i.e. WeWork) faced serious challenges . Finally in 2020, the COVID pandemic brought the work from home ((WFH)) era that has led many companies to question the need for offices at all. Looking to Same-Store (SS) occupancy levels reported by traditional CBD office REITs (SLG, BXP, ESRT, and VNO) shows that traditional CBD office REITs saw SS occupancy levels decline -470bps from pre-pandemic levels (i.e. 1Q20) vs. MOBs which saw SS occupancy levels increase +40bps since 1Q20.
Company data.
Despite having “office” in its name, and sometimes being categorized as part of the larger office sector, medical office buildings ((MOB)) are not only largely immune from the issues that have hit traditional CBD office, but actually stand to benefit from secular tailwinds. As healthcare spending in the US has reached unsustainable levels, we have seen an ongoing migration from the expensive inpatient (i.e. hospital) setting to the less expensive outpatient (i.e. medical office) setting.
Company investor presentation.
MOBs are not only poised to benefit from the migration toward the outpatient setting, they are also poised to benefit from demographic trends. As an increasing share of the baby boomer generation reaches the age of 65, physician office visits and healthcare costs should increase accordingly. Currently, 46% of baby boomers are over the age of 65, with the share of baby boomers over the age of 65 reaching 100% in 2030.
Company investor presentation.
While tele-health services gained popularity during the pandemic, HR’s portfolio consists primarily of medical office buildings that are considered to be on the campus of a hospital. This allows doctors that are employed by the hospital system to go back and forth between the inpatient (i.e. hospital) and outpatient (i.e. medical office) setting to perform procedures. The procedures typically performed in on-campus medical office buildings are higher acuity in nature, and therefore less susceptible to a migration towards telehealth services.
While many investors envision your typical “doctor’s office” when they think of MOBs, from my personal experience touring properties, I find the term “hospital without beds” to be a far more apt description. More recently, publicly traded healthcare companies HCA and Tenet reported that outpatient surgical procedures increased 5-8% y/y compared to 2% y/y in 2022.
Medical Office REITs are Under-Leveraged
MOB assets are well known among real estate investors as being extremely recession resistant with steady and predictable fundamental performance at the property level. This makes intuitive sense when you consider the non-cyclical nature of healthcare services, the predictable nature of contractual escalators, and the tenant health of large medical systems.
Company data.
Using the volatility of reported SS NOI growth rates over the past five years as a proxy for the volatility of the underlying unlevered operational cash flow from a property, reveals that MOBs are lower risk relative to CBD office and storage on almost every metric.
Over the past five years, the highest SS NOI growth reported by MOBs was +3.7% compared to +5.8% and +23.7% for CBD office and storage, respectively. While CBD office and storage both saw SS NOI growth fall deep into the red for multiple quarters during the depths of the pandemic, MOBs only saw SS NOI growth dip slightly negative (i.e. -0.2%) for one quarter in 3Q20.
It is not surprising to me that the standard deviation of reported SS NOI growth from MOBs over the trailing five years of 0.9% is only a fraction of that of CBD office and storage that saw standard deviations of 2.7% and 8.5%, respectively.
Company data.
Given that MOBs may be one of the lowest risk real estate asset classes from a fundamental perspective, it would seem logical that investors would not only tolerate, but encourage publicly traded MOB REITs to operate at higher levels of leverage given the relative safety of the properties’ underlying fundamentals. However, looking to reported net debt / EBITDA levels over the past five years reveals that this has not been the case.
Company data.
When it comes to leverage levels at publicly traded REITs, the rule of thumb since the GFC (Great Financial Crisis) has been net debt / EBITDA levels in the 5-6x range. While this may be an efficient capital structure for asset classes that are more volatile like CBD office and storage, I have long thought that the 5-6x level is too conservative for MOB REITs given the low volatility of their underlying cash flows.
Company data.
In 2017, several large MOB portfolios transacted (e.g. Healthcare Trust of America’s (HTA) acquisition of the Duke Realty MOB portfolio ) at sub-5% cap rates (a new low at the time). My thinking has been that this corresponds to around the time that institutional and international capital became fully aware of MOBs as an asset class and began to view MOBs as institutional quality assets.
While public REITs typically look at leverage from a net debt / EBITDA perspective and target a range of 5-6x, private real estate investors typically look at leverage from a Loan-To-Value (LTV) perspective and have historically been willing to tolerate levels as high as 70%.
For illustrative purposes, assuming cap rates are at 5% and interest rates are at 2.5%, a public REIT with a net debt / EBITDA level of 6.0x (equivalent of 30% LTV) can expect to achieve an ROE of 6.1%. On the other hand, a private equity investor who can invest at a 70% LTV (equivalent of 14x net debt / EBITDA) can achieve an ROE of 10.8%.
Analyst estimates.
Since 2017, I have been relatively bearish on publicly traded MOB REITs given their inability to lever up in order to compete against private capital on acquisitions. When a public REIT cannot engage in external growth in an accretive manner, I generally think that the REIT does not warrant to trade at a premium to its NAV per share. However, given where MOB REITs are currently trading, I think they screen inexpensive on a standalone basis (i.e. they are trading at a significant enough discount to NAV, that they are a good investment even without any external growth).
Prefer Internal Growth to External in the Current Interest Rate Environment
Publicly traded REITs have two avenues in which they can grow earnings (i.e. internal growth and external growth). Internal growth requires strong operating fundamentals, while external growth requires access to accretive sources of capital. Given the unprecedented rise in interest rates and the interest rate outlook of higher for longer, I have a strong preference for internal growth stories.
Google Finance.
After seeing several large medi cal office portfolios transact in 2017 a t sub-5% cap rates, I became incrementally more bearish on medical office REITs since I knew it would be more difficult for them to grow externally in an accretive manner given where their cost of capital stood.
Today, given the large differential between private asset valuations and public REIT valuations, I am even more bearish on external growth unless it is public-to-public, such as HR acquiring REIT peer HTA, since both companies’ stocks were trading in the public market which had quickly adjusted to a higher interest rate environment.
Unlike some REIT management teams that acquire assets for the sake of growth, HR’s management team indicated on their 2Q23 earnings call that they are net sellers in the current environment, and that their level of activity in the acquisition market in 2024 really depends on their cost of capital.
In terms of where private valuations are at, management teams have indicated that although transaction volume is muted, they are seeing high quality assets transact at cap rates around 6% with some assets transacting well into the 5’s. Given where HR shares are currently trading (a 7.2% implied cap rate according to my calculations), I think HR’s disciplined process speaks to the quality of the management team and an alignment of incentives that are conducive to shareholders.
On HR’s 2Q23 earnings call, HR management said they are selling non-core non-strategic assets at cap rates around 6.5%, and will use proceeds for share buy backs, debt repayments, and development funding. Given that HR shares are trading at a 7.2% implied cap rate, this provides HR with an opportunity to improve its portfolio quality and recycle capital in an accretive manner, which is relatively rare.
Company data.
Given where HR’s capital costs are currently, management is more focused on investing through JV’s (i.e. Joint Ventures) where they can generate accretion through JV fees. I have always considered HR’s management to be best in class, and I think their current discipline in terms of executing on external growth demonstrates their quality.
Medical office fundamentals remain strong with SS occupancy remaining fairly constant across the medical office portfolios of publicly traded REITs. HR’s 2Q23 SS occupancy of 89.0% is in-line with its average occupancy over the past five years (HR’s portfolio occupancy is consistently below peers given that its portfolio is primarily multi-tenant buildings as opposed to single-tenant triple net-leased properties).
Company data.
HR’s reported SS NOI growth of 2.0% in 2Q23, however, the company still expects 2023 SS NOI growth to average 2-3% in 2023, with SS NOI growth increasing to the 4-6% range in 2024 as the company recognizes more benefits from its 2022 acquisition of Healthcare Trust of America (HTA).
Company data.
HR’s Balance Sheet is in a Better Place than Investors Realize
When a merger such as HR acquiring HTA occurs, the acquiror is required by US Generally Accepted Accounting Principles (US GAAP) to mark the acquiree’s debt to market. Given the unprecedented rise in interest rates during the course of 2022, it should come as no surprise that HTA’s debt mark downs were significant. When the debt is marked down, the result is an increase in the GAAP interest expense that is recognized by the firm. However, what needs to be noted is that the increase in GAAP interest is not contractual (i.e. non-cash), and is added back to arrive at Adjusted Funds From Operations (AFFO).
When comparing HR’s weighted average interest rate to peer Physicians Realty Trust ( DOC ) investors may come to the conclusion that HR has a significantly higher interest expense burden, however, if you convert the GAAP interest expense to cash, the gap in weighted average interest rates on debt almost closes completely. For this reason, as well as others, I think it is important to look at earnings on an AFFO basis rather than an FFO basis.
Company data.
In terms of leverage, HR’s 2Q23 reported net debt / EBITDA of 6.6x is at the high end of its 6.0-6.5x expected range. However, accounting for the same acquisition benefit adjustment that I made previously (for HR’s implied cap rate) brings HR’s net debt / EBITDA down to 6.4x. Management mentioned on HR’s 1Q23 earnings call that they expect leverage to be at the high end of their 6.0-6.5x range by the end of the year, with the expectation of it decreasing further into 2024.
Company data, Analyst estimates.
While HR’s balance sheet may appear less appealing when comparing it to peer DOC, there are several aspects of HR’s reported balance sheet metrics that I think do not reflect economic reality. In addition to the two items mentioned above, HR also has a significant amount of interest rate swaps that decreases HR’s percentage of debt that is variable to 15% from 33% (reported).
Company data, Analyst estimates.
Valuation: Implied Cap Rate Matters More than Net Asset Value ((NAV))
HR’s current implied cap rate of 7.2% stands +138bps above its five-year average of 5.8%, and +138bps above its 5.8% level in 2Q20 (during the depths of the COVID pandemic). While rates are higher now than they were in 2Q20, I think several positive catalysts exist for HR over the next twelve months that should bode well for share price performance.
Google Finance, Company data.
While implied cap rate is the preferred metric by investors when evaluating publicly traded REITs, given the recent rise in construction costs, I think it also makes sense to view HR’s portfolio through the lens of replacement cost. HR discloses its current active development pipeline including budgeted development costs as well as square footage of each project. Taking HR’s total budgeted cost of construction and dividing it by the total square footage of the projects reveals that HR is currently budgeting $456 / SF for construction costs. HR’s current share price of $17.05 implies a value / SF of $273 indicating that HR’s portfolio is currently trading at a 40% discount to its replacement cost.
Company data, Analyst estimates.
While NAV may be an effective method for estimating a REIT’s private market value, during times like these when private market transactions have more or less come to a standstill as investors struggle to come to an agreement on what the appropriate price for an MOB is, I think it makes the most sense to look at a REIT’s cap rate that is implied by its share price (i.e. implied cap rate) relative to interest rates.
Given the low likelihood of HR being acquired outright given its larger post-merger size, I think that a DCF analysis is the most appropriate method for determining HR’s intrinsic value given that it incorporates higher rates in its cost of capital calculation while also accounting for maintenance capital expenditures in its cash flows (one aspect that is ignored by a traditional implied cap rate analysis).
Assuming the current 10-year Treasury yield of 4.26% persists for the long term, I estimate that a share of HR has an intrinsic value of $21.85. Considering HR’s current share price of $17.05, HR currently trades at a 22.0% discount to its intrinsic value despite several positive catalysts that I outlined above.
Google Finance, Analyst estimates.
Given the low risk profile of medical offices and public equity investors’ unwillingness to tolerate a leverage level higher than 6.0x net debt / EBITDA, an MOB REIT would normally be an ideal candidate for being acquired by a financial sponsor in a Leveraged Buy Out (LBO) transaction. However, given the current interest environment, it is more difficult to make the math work.
On HR’s 2Q23 earnings call, management mentioned that they have seen cap rates decline recently, and that investors are either investing with all cash, or using negative leverage with the intention of refinancing later when interest rates are hopefully lower.
Assuming a financial sponsor is willing to pay a 15% premium to HR’s current share price (i.e. an implied cap rate of 6.7%), and has access to senior unsubordinated debt at ~6.5%, I estimates that a financial sponsor could achieve an Internal Rate of Return ((IRR)) of 12.9% assuming an exit after five years at a 6.6% cap rate.
More realistic I think would be a financial sponsor targeting an IRR of 25%. For a financial sponsor to achieve a 25% IRR assuming the same facts as previously stated, HR’s share price would have to be bought out at $16.76, a -1.7% discount to its current share price of $17.05. Considering HR’s larger size after acquiring HTA and the current interest rate environment, I see HR being acquired in a Leverage Buy Out (LBO) transaction as an unlikely event unless its share price falls further.
Google Finance, Analyst estimates.
Given the low transaction volumes and wide bid-ask spreads in the private market currently, I do not think that trying to determine HR’s NAV per share is the best way to evaluate HR’s value. Instead, I think it makes more sense to look to its implied cap rate relative to interest rates.
Assuming the current 10-year US Treasury yield of 4.26% persists for the long term, HR should trade at an implied cap rate of 6.6%. I estimate that HR’s gross assets trading at a 6.6% implied cap rate in 2Q28 (i.e. five years from now) would equal ~$26. Assuming HR’s shares trade at $26 in 2Q28, an investor buying the stock today for $17.05 would achieve an annual compound capital return of 9% and an income return of 7% from HR’s dividend yield, resulting in all in average total return of 16% over the next five years.
Google Finance, Company data, Analyst estimates.
Bull Case
$23 price target represents a 42.2% total return and assumes HR's stock trades at a 6.1% implied cap rate, 6.3% SS NOI growth, and $200mn of real estate acquisitions at a 7.3% acquisition yield.
Base Case
$20 price target represents a 24.6% total return and assumes HR's stock trades at a 6.6% implied cap rate, 5.3% SS NOI growth, and $100mn of real estate acquisitions at a 6.3% acquisition yield.
Bear Case
$17 price target represents a 7.0% total return and assumes HR's stock trades at a 7.1% implied cap rate, 4.5% SS NOI growth, and very limited real estate acquisitions.
Conclusion
I believe investors who have looked at HR’s post-acquisition earnings have concluded that the acquisition of HTA was dilutive from an earnings and NAV standpoint. I think the market is missing the fact that the benefits of an acquisition of this magnitude typically take several years to be fully realized. I think the market’s view will shift as HR delivers SS NOI growth of 4-6% in 2024 and it reaps the full benefits of its acquisition of HTA. The combination of a pivot to earnings growth and HR trading at a slightly more positive implied cap rate that is more appropriate given where interest rates currently stand, should deliver more than adequate risk-adjusted returns to investors given the low-risk profile of MOBs.
For further details see:
Healthcare Realty: 5-Year Low Valuation Due To Short-Term Earnings Dilution From Acquisition, Buy