Physicians Realty Trust: The Doctor Is In – Physicians Realty Trust (NYSE:DOC)

Introduction

In the fast-growing and quickly-changing healthcare sector, Physicians Realty Trust (NYSE:DOC) is one of several REITs that are benefiting from continued strong demand and ever-increasing spending on such services and related properties. One of the more efficient net lease REITs in the sector, DOC is using greater expertise with physicians groups and deeper client relationships to build truly accretive and long-lasting partnerships with tenants. This focus on client and relationship quality is more important than ever, as traditional growth drivers have somewhat stalled as rising asset prices have made acquisitions much less attractive than in past years. While this is something of a competitive advantage, asset, FFO, and dividend growth have all but stalled the last couple of years, mostly due to a frothy medical real estate market. Given that, and the lack of truly accretive projects in the pipeline at the moment, combined with an already-stretched dividend payout, I am neutral on the stock at the current price. That said, the underlying business model is sound, and given a 10-20% drop, I do think shares would become attractive.

(Image source: Physicians Realty Trust investor website)

A Growing Healthcare Industry

In one of my recent articles on one of DOC’s competitors, Healthcare Trust of America (NYSE:HTA), which can be found here, I talked about the changing nature of the healthcare industry as it pertains to inpatient vs. outpatient care. Essentially, surging demand for healthcare services and rising costs across the industry are making inpatient hospital care less and less economically sensible or feasible, which means that outpatient care is increasingly favored as a more cost-effective alternative. Certain healthcare REITs stand to benefit from the resultant burgeoning demand for medical office buildings (MOBs), and DOC has positioned itself as one of those beneficiaries. Though the company does not exclusively focus on MOBs and has some key relationships with hospitals and inpatient facilities, outpatient revenue growth has been more impressive.

Shifting the Focus

Management is focused on a few key property types: MOBs, outpatient treatment and diagnostic facilities, physician group clinics, ambulatory surgery centers (‘ASCs’) and specialty hospitals and treatment centers. What DOC seeks to do is focus on investing in properties of healthcare firms that exhibit dominant market share, high credit quality, with an eye specifically toward on-campus locations. In this way, the firm hopes to achieve vertical integration and economies of scale within particular markets to develop more valuable and accretive partnerships with high quality tenants. While DOC has always stressed its focus on investing in assets with attractive demographics, demonstrated economic growth, and high barriers to entry, less favorable cap rates have made the quality focus more strategically important than ever before, as far as management is concerned.

DOC tenant quality(Table source: DOC 2019 annual report)

DOC’s shifting investment focus has seen the firm become more selective in which development projects and acquisitions it engages in, through joint ventures or fee arrangements with top healthcare real estate developers. Generally, the company restricts new investments to development properties that show 80% or more pre-lease commitments, to mitigate occupancy risks, and guarantee sufficient immediate cash flows.

DOC portfolio growth(Image source: DOC investor presentation)

As management freely admits, it only seeks out significant portfolio growth “when capital markets permit,” referencing not only lower cap rates for new projects but also what management perceives to be an unwarranted discount for off-campus properties (relative to on-campus assets). Additionally, management tries to tap equity markets for subsequent property acquisitions at more advantageous stock prices, and the last couple of years have seen poor underlying share performance. Due to the current unfavorable environment for portfolio growth, DOC has instead chosen to focus on asset integration and operational improvements for its existing properties, as well as portfolio and revenue diversification when possible.

Being Selective

As cap rates have come down, acquisitions have become less attractive. For example, in February 2014, the Peachtree Dunwoody property in Atlanta, GA fetched a 7% cap rate, but more recently, the ROFR portfolio additions (5 properties across 3 states) fetched a weighted average cap rate of only 4.7% in late 2017. For the capital commitments required to make truly accretive acquisitions, sub-5% cap rates are somewhat prohibitive, and any additions must be of the highest quality to compensate for such premiums.

DOC rental revenue(Chart source: author; data derived from Seeking Alpha DOC stock page)

While it could be viewed as a mounting opportunity cost, especially if higher asset prices persist for long periods of time or represent a structural shift, it would appear generally prudent to require a minimum IRR for each acquisition, given the attendant risk. In the meantime, DOC is using its cash flow to make property improvements, enhance operational efficiency, and focus on same-store rent growth. Also, dividend growth remains flat, at least until cap rates and FFO growth return to reasonable levels. That said, funds available for distribution have actually grown more than peers since 1Q15 at 38% vs. 7% for Healthcare Realty (NYSE:HR), and -3% for HTA.

DOC 2019 investment summary(Table source: DOC 2019 annual report)

While 2019 was not exactly a banner year in terms of overall portfolio growth, given the circumstances, management still managed to make $257 million in investments (92% of which included investment-grade tenants) across roughly 15 properties, at a weighted average cap rate of 6.2%. While opportunities for growth remained muted, there were a couple of important developments in key market segments. For one, El Paso Specialty Hospital and MOB saw an unexpected facility closure as tenant Surgery Partners ceased operations. DOC managed to replace the tenant within a couple of quarters (leasing the property to Tenet Healthcare (NYSE:THC)), and the subsequent cash NOI was actually even higher than the original purchase yield with the prior tenant (8.6% vs. 7.7%). Management’s quick response to this sudden change of events really highlights the firm’s leasing efficiency and underscores why the firm is able to consistently maintain the highest occupancy rates among its peers (96% currently).

DOC tenant bankruptcy(Image source: DOC 2019 annual report)

The Portfolio

Also, in 2019, the University of Louisville’s acquisition of the KentuckyOne Health Louisville area assets helped to diversify the client base and dropped CommonSpirit’s proportion of portfolio annual base rent (‘ABR’) from 20.1% to 16% (as of 3Q19). Overall, the portfolio is relatively well-diversified, as it has properties in 31 states, with no MSA representing more than 8% of leasable square footage, and no single tenant responsible for more than 6% of ABR. With 13.9 million GLA (gross leasable area), DOC derives 89% of that space from on-campus medical facilities and sports a weighted average remaining lease term of 7.4 years for its portfolio.

DOC tenant profile(Image source: DOC investor presentation)

Of the NOI (net operating income) the firm brings in, 93% comes from MOBs (medical office buildings), 5% from specialty hospitals, and 2% from long-term care facilities, showing how it largely stands to benefit from the expanded use of outpatient facilities, in place of in-patient hospitals. Geographically speaking, while the top 6 states account for 50% of portfolio GLA, Texas takes the top spot at 14%, which is not a bad thing, considering that market’s growing demand for healthcare. Looking at specific tenants, 20.1% of ABR derives from one tenant (CommonSpirit Health) as mentioned previously; fortunately, that tenant is an investment-grade health services operator with a BBB+ rating. Overall, the top-10 locations/properties account for roughly 30% of ABR, showing the relatively large size of its biggest assets. Still 49.2% of ABR and 52.5% of GLA comes from investment-grade tenants, so what the firm may lack in revenue mix and diversification, it makes up for in the quality and dependability of that revenue.

DOC portfolio snapshot(Image source: DOC investor presentation)

Flexibility Leads to Profitability

One thing DOC prides itself on is its ability to work with and add value to the relationship with its tenants, which it hopes will create deeper, more profitable partnerships in the long-run. To better illustrate its working relationship with tenants, let’s take a look at a case study: Foundation San Antonio Hospital was assigned to a joint venture between the occupying physicians and USPI (a mid-size ASC/hospital operator which should help improve operational efficiency at the facility). Under the lease agreement, amendments were put in place that allowed the tenant to defer some of the rent, in exchange for a 7-year lease extension and a back-ended rental increase, which would result in an overall increase of 6.4% ($904k) through 2024. Through the first 3 years (2019-2021), the tenant gets to defer a total of $2.312 million in rent payments to afford it some badly-needed financial flexibility as it works to improve operations. This kind of leasing flexibility can end up producing efficiencies for tenants, which is ultimately accretive to both landlord and tenant, a true win-win type of situation.

DOC leasing flexibility(Image source: DOC investor presentation)

Peer Comparison

Compared to its peers, DOC has a relatively high lease %, standing at 96% vs. 90.6% for HTA, and 87% for HR, for example. Also, the weighted average remaining lease term of 7.4 years is substantially longer than the 5.6 and 4 years of the previously mentioned REITs. Looking forward, between 2019 and 2023, DOC projected fewer lease expirations as well, coming in at 19% vs. 47% (‘HTA’) and 59% (‘HR’). Not only does DOC demonstrate greater leasing efficiency than direct peers, it also shows greater operational efficiency, as its recurring capex/cash NOI comes in at only 6.3% vs. 12.1% and 16.6% for HTA and HR, respectively. Additionally, 2019 showed strong MOB same-store cash NOI growth, of 3.2-3.5% (over the targeted range of 2-3%).

DOC leasing profile(Image source: DOC investor presentation)

Portfolio Developments

Off-campus MOBs have traditionally traded at a discount to on-campus ones, due to a higher perceived safety from larger on-campus health systems, but DOC’s management sees this as being mispriced, as off-campus properties are generally much more valuable and dependable than they used to be. As it stands today, cap rates for off-campus development projects are 6.5%, vs. 6% for on-campus, and DOC sees an opportunity in this unwarranted (according to their view) disparity. Beyond favoring off-campus properties for development, management has focused on recalibrating the existing portfolio and improving the overall quality of its existing assets.

Due to strong asset valuations (in 2018), we capitalized upon the opportunity to sell older, less strategically valuable properties and replaced them with better, bigger, and more modern medical office facilities occupied by high-quality health system clients that expanded upon our existing relationships and improved our financial base.”

– John T. Thomas, president and CEO of DOC

DOC cap rates(Image source: DOC investor presentation)

As of year-end 2018, DOC had acquired $4.4 billion of real estate since inception and increased its average property size from 50,000 to 54,000 square feet, by “pruning older, smaller-sized facilities” and grew its proportion of investment-grade tenants from 49% to 53% (of GLA). In 2018, the firm disposed of 34 smaller properties (31,000 sq. ft average) that were 82% leased and 74% on-campus/affiliated. That same year, DOC acquired 4 assets for $252 million at an average GLA of 155,000 sq. ft. that were 96% leased and 100% on-campus/affiliated (showing a different acquisition strategy to its development strategy). DOC has been working to improve its tenant profile, and as cap rates have come down has used its capital selectively, focusing on tenant and property quality.

By stressing collaborative relationships with tenants and a consistency of execution, DOC also tries to build more profitable partnerships. Strategic capital investment is a value-add, which enhances operational and financial efficiency. Additionally, a staggered lease expiration schedule and debt maturity schedule both lead to more consistent cash flows and long-term certainty and income stability.

DOC lease expiration schedule(Table source: DOC 2019 annual report)

Fundamental Picture

At a current P/FFO of 18.95, DOC trades at a slight premium to peers, given the sector median of 16.72 (as of 1/18/20). However, the 4.85% yield compares favorably to the 4.26% sector median. Of course, the 4-year average yield for the firm has been even more impressive, coming in at 5.56%, which draws attention to the low dividend growth over the last few years. The FFO payout ratio of 89.92% appears to reinforce the wisdom of management’s decision to hold on any dividend increases, which were particularly high, to begin with. Trailing 5-year revenue growth of 59.5% is certainly far above the sector median of 8.5%, which mirrors the superior EBITDA growth over the same period (62.8% vs. 8.3%), so a premium over peers appears warranted, but the dividend has little room for growth in the near term, so investors will want to bear that in mind as well.

DOC ffo payout ratioDOC dividends(Above two charts source: author; data from Seeking Alpha DOC stock page)

Conclusion

While DOC undoubtedly benefits from the trend away from inpatient care in favor of more affordable outpatient care, MOB demand is only one key component of its growth story. Focusing on building lasting relationships with dependable and financially-sound partners, while offering greater operational expertise in physician-centered properties than peers, has led to greater vertical integration and economies of scale. As asset prices in the sector have soared, and cap rates come down, management has wisely pumped the brakes on portfolio expansion as existing opportunities are much less attractive than before. While I like that strategy and think it shows a prudent approach given the circumstances, portfolio consolidation may lead to lackluster returns in the short-to-intermediate term. Also, cap rates may be structurally lower than before, given high MOB demand, that’s unlikely to change anytime soon, so I do think that DOC will have to adjust its expectations somewhat, but overall, I still like the cautious approach and think that DOC is one of the better REITs in the sector.

DOC p/ffo(Chart source: author; data derived from Seeking Alpha DOC stock page)

At a forward P/FFO of about 19, and a forward dividend yield of 4.79%, I think this medical REIT trades at a slight premium, given its lack of recent dividend, FFO, or asset growth. That said, the improving portfolio, focus on operational efficiency, and commitment to delivering value to tenants is a winning long-term strategy. This is one of those situations where I love the underlying business, but I am much less enthusiastic about the stock. At current prices, and given the short-term market fundamentals and immediate growth prospects, I’m neutral on DOC. In the long term, I am generally bullish on the company, but I would consider either waiting for a 10-20% drop in the share price, or dollar-cost-averaging into the stock if you’re initiating a new position. Over the very long-haul, I think a rising tide will lift all boats in the sector as MOB demand continues to grow, and as one of the better REITs in the category, DOC should be a winner overall.

DOC stock performance(Image source: Seeking Alpha DOC stock page)

*Relevant documents (all charts created by author, including many not included in the body of the article, and sourced to related data within attached Excel workbooks; financials drawn from either Seeking Alpha DOC stock page or StockRow DOC stock page):

DOC income statement

DOC balance sheet

DOC cash flow statement

DOC metrics

DOC charts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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