Good morning, and welcome to the Healthcare Realty Trust second quarter earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Todd Meredith, CEO. Please go ahead.
Thank you. Joining me on the call today are Rob Hull, Kris Douglas, Bethany Mancini, and Carla Baca. After Ms. Baca reads the disclaimer, I'll provide some initial comments, followed by Ms. Mancini with an update on healthcare policy and trends, Mr. Hull will discuss investment activity, and Kris Douglas will cover financial and operating results before we move to Q&A. Carla?
Thank you. Except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risk, and uncertainties. These risks are more specifically discussed in a Form 10-K filed with the SEC for the year ended December 31st, 2017, and in subsequently filed Form 10-Qs. These forward-looking statements represent the company's judgment as of the date of this call. The company disclaims any obligation to update this forward-looking material. The matters discussed in this call may also contain certain non-GAAP financial measures, such as funds from operation, FFO, normalized FFO per share, normalized FFO per share, funds available for distribution, FAD, net operating income, NOI, EBITDA, and adjusted EBITDA. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release for the second quarter ended June 30th, 2018.
The company's earnings press release, supplemental information, Forms 10-Q and 10-K are available on the company's website.
Thank you, Carla. We are pleased to report another quarter of solid performance. Same-store NOI grew at a notable pace above 3% annually, generated by healthy contractual rent bumps, cash leasing spreads over 6%, tenant retention well over 80%, and positive sequential absorption. Overall, a strong quarter for the company's core fundamental operations and long-term sustainable growth. Healthcare Realty's competitive advantage is derived from its hands-on leasing and management expertise and well-honed investment criteria, sharpened by more than two decades of experience, resulting in a highly regarded MOB portfolio with robust performance and intrinsic value. The quality of cash flows derived from MOBs stands out relative to many other healthcare property types, namely senior housing and skilled nursing, where wage pressures, competitive supply, and reimbursement challenges have led to thin rent coverage, forcing a number of REITs and their financially strained operators to reduce and restructure rents.
There's a stark contrast in risk between these healthcare property types, a difference we see as mispriced in today's market. Investing in MOBs is an immensely safer business model, aligning with A and double A-rated health systems in high-growth, densely populated markets, housing the expanding need for outpatient services, and generating rents from tenants who average 4,000 sq ft and cover their rents 8 to 10 times. The diversity and steadiness of cash flows from Healthcare Realty's MOBs is central to our ability to proactively manage the portfolio and afford the necessary costs of redeploying disposition proceeds into more attractive properties. Having stable internal growth also allows us to be patient during periods of divergence between public and private valuations and remain well prepared to invest as public capital costs and property-level valuations realign.
While public MOB REIT valuations have partially recovered, they remain undervalued relative to the robust private bid for MOBs. This is particularly true for Healthcare Realty, where we have demonstrated the ability to select the right combination of properties and apply our expertise to generate superior internal growth and steady cash flows. In the transaction market, MOBs remain well valued across the board, with buyers affirming cap rates of ±5%, with clear premiums for size and quality. With deep market support from private institutional capital, we expect no change in cap rates in the near term. Public MOB REITs have been much more volatile and are currently valued more than 50 basis points above recent transaction levels. Healthcare Realty has issued no equity in 2018 and used very little incremental debt, thanks to a conservative balance sheet and relatively modest capital needs.
We have been actively investing in recent months, recycling proceeds from asset sales into more sustainable cash flows with yields at or above our implied cap rate. As we continue to monitor transaction flow for quality investments, we've yet to pass on anything solely due to price. We are seeing a steady rise in the availability of attractive investments, both acquisitions and development, as outpatient healthcare delivery remains a top priority for health systems. A means to expand their market presence while also shifting care to the lowest cost setting, consistent themes in our conversations with health systems. Demand for outpatient properties has been growing for over 25 years and will continue as a tangible solution in the quest to curb rising healthcare costs and improve outcomes.
The need for outpatient capacity is expected to accelerate over the coming years as the front end of the baby boomers reach their mid-70s. Looking ahead, we will continue to allocate capital judiciously, investing at accretive yields relative to our implied cap rate. With a solid balance sheet, ample liquidity, and multiple capital options, we are well positioned to create value through selective investments. In addition to traditional sources of debt, equity, and dispositions, we continue to carefully evaluate asset-level joint ventures, a viable alternative if the public-private valuation gap persists. Most importantly, we will continue to apply our operational know-how to bolster performance, a competitive advantage in today's pricing environment, and we will selectively invest with discipline safely and profitably for the long term. Bethany?
The tone in Washington has been largely optimistic for healthcare providers so far this year, with a quiet legislative front and balanced regulatory proposals. The Centers for Medicare & Medicaid Services announced its 2019 physician fee schedule proposal, generally positive on the whole, with measures to lessen the regulatory and reporting burden for physicians. The proposal includes an exemption from value-based reimbursement policy, known as MACRA, for practices with relatively low Medicare patient populations, allowing physicians some flexibility in adopting new payment methods while continuing to meet the demands of what largely remains a volume-based care system. CMS also proposed higher rates for ambulatory surgery centers in 2019, as well as for hospital-based outpatient services. The latter increase mostly offset by their site-neutral payment policy to bring payments for clinic visits in off-campus locations in line with lower comparable physician office rates.
This represents an ongoing effort by the CMS to curb incentives for hospitals to acquire off-campus outpatient practices or add new providers and services to existing off-campus locations and charge higher hospital-based rates. On-campus outpatient Medicare rates remain stable. 79% of Healthcare Realty's MOBs are located within 250 yards of a hospital, pointing to the on-campus integration of our facilities and strong demand fundamentals. Regardless of the direction of site-neutral policies down the road, we are confident the expansion of outpatient facilities will be supported on and off campuses, both from the perspective of payers as well as health systems. Within the landscape of regulatory changes, government reimbursement, insurance challenges, and the like, hospitals and physicians remain focused on increasing market share and financial alignment in positive demographic markets.
According to a recent survey by the 2018 Advisory Board of Health System CEOs, the top strategic concerns among healthcare executives were pursuing sustainable cost controls and increasing revenue growth, both being achieved through the enhancement of outpatient care delivery. These strategies far outranked health systems' other more publicized initiatives, including population health management, accountable care organizations, MACRA, IT, and other health reform-related efforts. Hospitals are shifting more low-acuity care to outpatient lower-cost settings, and at the same time, more specialty procedures are now being able to be performed on an outpatient basis. While this trend has pressured inpatient hospital volumes, health systems are centralizing higher acuity patients at acute care hospitals, thereby increasing revenues per inpatient admission. Combined with growth in outpatient revenues, health systems with dominant market presence are seeing higher profit margins. We view health system and physician interdependence as stronger than ever.
The importance of physicians, specifically to the direction of patients, promotion of outpatient service growth, and revenue generated for hospitals, emphasizes the critical nature of a strong physician presence on hospital campuses. Additionally, the potential for fewer Stark Law regulations currently under consideration in Congress could also lead to stronger physician-hospital financial ties and their connection to the hospital campus. These meaningful trends should benefit Healthcare Realty's portfolio of medical office buildings and its development of new facilities affiliated with top credit-rated health systems in top MSAs. Having a broad base of physician tenants across more than 30 specialties, relatively lower concentration of Medicare and Medicaid patients, and high rent coverage, Healthcare Realty will continue to capitalize on the inherent growth and stability of its properties in the years to come. Rob?
Healthcare Realty had a productive investment quarter, purchasing five buildings for $70.4 million at a blended first-year yield of 5.9%.
Primarily funding them with $55.7 million of disposition proceeds received in the quarter. The properties acquired, totaling 370,000 sq ft, are in Seattle, Denver, and Oklahoma City. All five are located on or adjacent to hospital campuses associated with leading health systems, with four of the five on campuses where we already own buildings, and two providing future redevelopment opportunities for the company. The market for medical office buildings remains active, with pricing essentially unchanged from last year. We are seeing cap rates for individual MOBs and smaller portfolios in the mid 5% range, and pricing for larger portfolios at about 5%, with a couple of sizable transactions in the mid fours, including a well-publicized asset that recently traded in Houston. Consistent pricing in the private market over the past year stands in stark contrast to the volatility in public market valuations, giving rise to a valuation gap.
As a result, the company's acquisition guidance for the year remains $75 million-$125 million, in line with our disposition guidance. When the relationship between our implied cap rate and asset pricing improves, we will revisit acquisition guidance. Disposition activity included the sale of seven properties in Roanoke, Virginia, as a result of a fixed-price purchase option for $46.2 million and five skilled nursing facilities in Michigan for $9.5 million, bringing total sales for the year to $55.7 million. For the remainder of the year, we expect additional dispositions of around $50 million at a blended cap rate of 5.5%-7%. Turning to development, we continue to see steady leasing demand at our two projects in Seattle and Charlotte, scheduled for completion in the first half of 2019.
We are also making steady progress on a couple of projects that should start within the next several quarters as we work with hospitals on their outpatient programming initiatives. Our investment approach, including acquisitions, is done with an eye towards incremental development and redevelopment. Investments with expansion potential give us more control over timing and the ability to capture future demand and will generate better yields compared to widely marketed developments. We have identified over 1.5 million sq ft, representing three-quarters of a billion dollars of development and redevelopment potential embedded in the portfolio. Half of this potential involves the replacement or expansion of existing properties, with the other half being ground-up development on excess land associated with MOBs we've acquired.
While it will take many years to harvest this potential, we are in continuous discussions with multiple hospitals on a handful of projects totaling around 200,000 sq ft that could translate into one or two incremental development starts in the next 12 to 24 months. With ready sources of capital, including dispositions, and an ample pipeline of investment prospects, we are well-positioned to invest accretively relative to our implied cap rate in the second half of 2018 and into 2019. Kris?
Normalized FFO for the second quarter was $49 million, flat over the first quarter. With no shares issued, normalized FFO per share remained unchanged at $0.40. Our strong internal growth and operational efficiencies helped to keep sequential quarterly FFO steady, even as we continued our initiative of rotating out of off-campus, slower-growth properties and into on-campus, multi-tenant MOBs with greater long-term value. A $600,000 increase in NOI net of straight-line rent and a $700,000 reduction in G&A expenses offset a $400,000 increase in interest expense and $800,000 of net dilution from the partial period impact of dispositions and acquisitions in the second quarter. Looking ahead to the third quarter, we expect an additional $500,000 of net dilution from the second quarter dispositions.
While we expect continued revenue growth from contractual escalators, typical third quarter seasonal utilities, which can increase expenses by as much as $1.5 million over the second quarter, will likely result in no increase in sequential same-store NOI. This typically reverses in the fourth quarter to more normal levels of $700,000-$900,000 in sequential NOI growth. Shifting to portfolio NOI for the quarter, total trailing 12-month same-store NOI increased 3.2%, with single-tenant net lease assets growing 3% and same-store multi-tenant properties growing 3.3%. As expected, single-tenant NOI growth continued to improve in the quarter, increasing 5.8% over the second quarter of 2017.
The improvement was primarily driven by two large leases with non-annual escalators greater than 5% that occurred in late 2017, as well as a lease that commenced in March of last year that had a couple of months of rent concessions, resulting in a partial period of rent in Q2 2017 versus a full quarter of rent in 2018. Within our multi-tenant same-store portfolio, revenue grew 2.9%, driven by a 2.6% increase in revenue per average occupied square foot and a 20-basis-point increase in average occupancy to 88.4%. This revenue growth, combined with a modest 2.2% increase in operating expenses, created operating leverage that generated multi-tenant same-store NOI growth of 3.3%. Our leasing and management team continued to execute well, boosting key drivers of internal revenue growth, specifically in-place contractual increases and cash leasing spreads.
In the quarter, average in-place contractual increases continued to make steady marginal improvement at 2.84%, compared to 2.81% in the first quarter and 2.68% eight quarters ago. Future contractual increases for leases executed in the quarter were 3.2%, which is above the average in-place contractual increases, pointing to accelerated growth in future periods. Cash leasing spreads were 6.4%, with over 92% of the renewed leases having cash leasing spreads of 3% or greater. A few comments on our maintenance CapEx, which totaled $28.7 million year-to-date. We had three items worth noting in the quarter. First, we had $900,000 of second gen TI that was over and above our allowances, and thus the tenants will reimburse us in the coming quarters for the overage. These reimbursements were not netted in our TI spend disclosure. Second, we spent $2.1 million on move-in-ready suites.
Year-to-date, we have built out or are underway with 40,000 sq ft of move-in-ready suites and have leased or have under LOI half of the space so far. Although we don't break out revenue-enhancing capital, these dollars should boost absorption and future revenue. Lastly, we funded $1.4 million of capital expenditures associated with projects underwritten as part of acquisitions. However, this spending fell into maintenance CapEx because it took longer than our timeframe for inclusion in our planned acquisition capital. Including these three items, our FAD payout ratio through the first two quarters of 2018 was 98%. Without them, our FAD payout ratio would've been approximately 94%. While the stock price has risen 13% over the last couple of months and improved our implied capitalization rate to approximately 5.6%, we do not currently have plans to issue equity to fund investments.
With $465 million available on the line of credit, debt-to-EBITDA of 5.1x, interest from private capital to form JVs, and a healthy pipeline of dispositions for the remainder of 2018, we are well-poised to make investments that will generate operating leverage and continue to drive robust internal growth. Todd?
Thank you, Kris. Operator, that concludes our prepared remarks. We're ready to begin the question and answer period.
We will now begin the question and answer session. To ask a question, you may press star, then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. The first question comes from Vikram Malhotra of Morgan Stanley. Please go ahead.
Thanks for taking the question. Maybe just first question, you alluded to kind of the CapEx being elevated for certain items and [inaudible], the FAD payout being 94. Can you just maybe walk us through your thought process over the next, call it six to 12 months? Where would you like to get that payout ratio, and what parameters, what are you watching to see, or monitoring such that you could start maybe raising the dividend?
Thanks, Vikram. As Kris walked through, obviously 98 is the FAD payout ratio year-to-date, and then with some of these adjustments to that 94 level. I think if you look at 2017, we're right in the middle of that, a little over 96%. I think as you've heard us say before, this year probably looks a lot like last year on average, and I think the second half of the year should fall sort of in that range as well. I think really it's talking about 2019 and where we see that going, and I think certainly as internal operations continue to perform well, we see that improving incrementally, each quarter and each year, especially going into 2019. I think our view is, we clearly want that to continue to go down over time.
With internal growth being the driver of that, it's not going to be huge stair steps. It will be incremental progress. I think as we go through 2019, we expect to see that come down a bit. Longer term, where we'd like certainly it to go would be below 90% certainly, and I think that's certainly what it takes before we talk about getting to incremental dividend increases. I think our view is we'll continue to address that in the coming quarters, give some insight, as we get closer to 2019, and continue to monitor that and give some thoughts as to how we look at that in terms of coverage and dividend increase.
One thing I would add to that, Vikram, is as Todd mentioned, we expected 2018 to be pretty similar to 2017. As we talked with many of you about, a lot of that has to do with the fact of selling single-tenant net lease buildings and buying multi-tenant buildings. All $55 million of dispositions that we've done so far this year were single-tenant net lease, which don't have much, if any capital, especially on a run rate basis. As you go through that transition, we knew that that was going to kind of put a pause on us driving down the payout ratio, but we still think that it's the right decision and will help drive long-term value and growth as we're able to get better internal growth out of our multi-tenant properties than we see out of the single-tenant net.
Okay. Then just one more. You talked a little bit about the redevelopment and development potential over the next few years. Can you help us? Give us more context, give us some more numbers around it. What sort of opportunities are these? Just maybe overall, what level are you comfortable at in terms of taking the development pipeline/redevelopment opportunities?
Sure. Todd?
Thanks, Vikram. I think if you look at the pipeline that I described, we really view those as long-term opportunities. As we've said, some of those are potential developments on excess land acquisitions that we've acquired. Some of them are potential redevelopments of existing buildings. We view that as a long-term development potential. I think if you look at the rate that we've projected in terms of what we'd like to do in development, it's still in that $50 million to $100 million range. That range is generally made up of some redevelopment opportunities, as you've seen with our Charlotte redevelopment, but it also includes outside development opportunities. We look at this longer-term pipeline as really additive to that, or helps us get to that higher end of that $100 million range.
We still think that $50 million to $100 million a year is the right range for us. Depending on leasing of those developments and where they are, we could get to the top end of that range. I think really long-term, that development, that pipeline that I described, is more additive to our existing efforts. Really the key there is, in all of those situations, we control the opportunity, either through fee simple land that we own or a long-term ground lease that we have. Those are well-located on or adjacent to campuses and kind of keeps us out of the reliance on marketed opportunities.
What yield are you targeting on those opportunities, those redevelopment opportunities?
Generally, the yields that we're looking at, we've said before that those are typically 100 to 200 basis points above where we're seeing similar stabilized assets yield. Our guidance on the acquisitions right now is 5.25%-6%. We would look at 6.25% up to 7.5% on those opportunities.
Okay, got it. Thank you.
The next question is from Jordan Sadler. Please go ahead.
Thank you. Good morning. Can you give us a little bit of insight into what a potential joint venture might look like for you guys? Would it be a stabilized asset joint venture that you would seed with assets and look to grow with essentially a cheaper cost of capital, or would it be the pursuit of new assets altogether?
Sure, Jordan. I would say both is the answer. I think we will look at both of those. We're certainly having discussions around that. We've, for some time, more than probably a couple of years, talking to different private capital sources. As you've seen out in the market, that has certainly ramped up more so lately. I think we would certainly look at both. You've seen some of those transactions, just recently yesterday, an announcement on a sale of properties, turned around and invest in some more properties. I think both of those would be things on the table, and I think as you know us to be very disciplined and selective, we're being thoughtful about that process, not only what the structure looks like, but who we're partnering with, and how that fits into the bigger picture.
We continue to evaluate that, and really more importantly, I think just being prepared for that depending on sort of where the market dynamics play out in terms of the public versus private valuation levels.
Okay. Just another question. You guys talked about where you're seeing cap rates. Obviously, the private market bid continues to be pretty aggressive. You guys are trading at five, six cap, and we've seen select assets, as you described, trade pretty aggressively in the mid to low 4s, I think. Any thoughts on how else to sort of narrow the gap vis-à-vis your portfolio valuation and quality versus private market?
Sure. Certainly, the prior question gets to that point with the JV structure, looking at different sources of capital, other than equity and traditional debt sources. That certainly is one. I think certainly patience is important here. Obviously, last quarter, about a quarter ago, we were all looking at this, and we were probably at an implied cap rate of closer to 6%. Not saying that waiting is a strategy necessarily, but I do think patience is a virtue. I think one of the things that we certainly saw a quarter ago is that we didn't all have great information on the transaction market, and the question was out there, would the private market continue to support a strong bid for MOB, or at least as strong as everybody had seen last year?
I think a quarter later, everybody can confidently say that is certainly the case, that the private investors, institutional capital, have created a strong level of support at the same levels as last year. I think a lot of that is education and understanding for all of us that participate in this market, and I think that will continue to help close that gap. Obviously, as you said, we're looking at other proactive things we can do. Clearly, our internal growth model drives us towards that. I think further appreciation of that is good, but continuing to be thoughtful about dispositions and redeploying that capital, and just being mindful and not getting too eager to invest before it makes sense profitably.
Just one last follow-up on the point. If you were to give us a guideline on the scope of the portfolio that has a growth profile that is below what you have been targeting, about how big is that portfolio today, meaning sub 3% escalator or more of a flatter type rent growth profile?
It is pretty small these days. If you look at some of our disclosure around our average contractual increases, I think over 90% of our leases, this is multi-tenant specifically, have contractual escalators that average just under 3%. It has gotten pretty small, and certainly that reflects all the work over the years that we have been doing to try to get to your point, which is trying to cull the portfolio and find those things that are not growing as well as we would like. I think single tenant, as Kris described earlier, is certainly an area where we have been working on that over time, and on top of that, non-MOB type properties. You have seen a lot of that from us. We just find that generally single tenant, and this largely indicates off-campus as well, tends to grow closer to 2%. Our average single-tenant escalator is 2.13%.
Clearly a stark contrast with something closer to 3. I think you will see at the margin that continues for us. We are okay with some single tenant. There is certainly some good investments out there that are off-campus or single tenant. We will always sort of be biased towards that multi-tenant for the reasons of growth. I would say less than 5%, to answer your specific question.
Okay. Lastly, any color you can provide around the Michigan SNF portfolio sale in terms of that cap rate?
Yeah. That was a cap rate, I think we disclosed last, a little over 25%. It was five buildings that we sold that were in small markets in Michigan. The properties were about 45 years old, and we sold it to an operator in Michigan who was the second-largest operator in Michigan, and we felt like they could pay the most for it, we felt like it was a good transaction. The operations in those buildings had dropped off from occupancy there from the low 90s down to the low 70s. Cash flow was deteriorating.
The previous operator was exiting the market.
Yes, that's right.
Okay. Were they covering?
No, they were not covering.
What was rent coverage like? It's fallen below one.
It was below one.
It was certainly below one and had been dropping, and we could just tell with the operator, in terms of their focus of leaving the market. They had sold a fair amount of other properties and exited, that they were not the people that were going to be able to turn around. The question was, do you go through and try to recut a lease with a new tenant who is going to need to put capital and take some time to turn the operations around? Is it just better to sell and move on? We decided, given our focus, that it was better just to sell and move on at that point.
Okay. Thanks, guys.
Thanks, Jordan.
The next question is from Chad Vanacore of Stifel. Please go ahead.
Thanks. My call's been in and out, I'm going to apologize if this has already been answered. Cash re-leasing spreads were elevated. They were at 6.4%, and it's been pretty well elevated in the last couple of quarters. What leases are driving that, and why?
I would say generally, it is pretty deep and wide. As I mentioned, we had 93% of our leases that were 3% or greater. I will point out there was one lease this quarter that skewed a bit higher. It was for an off-campus building where the hospital wanted to expand and is doing some reprogramming. We did agree to provide them some additional capital associated with that. Our TI per square foot per lease year was higher than average. I think it was around $3.81 for that deal, and we had a 17% cash leasing spread. If you excluded that one deal, the cash leasing spreads were still 5%, and our TI per square foot per lease year would have been $1.78, which is right in line with what our average was for 2017.
There was one, like I said, that skewed a bit higher, but even excluding that one, still very strong. Like we always say, long term, we think that the right level is 3%-4%. When you do have opportunities where you have something that can be a bit outsized and keep those negatives as minimal as possible, then that certainly helps your average.
Chad Vanacore, that particular deal that Kris Douglas mentioned was, I think, 47,000 feet.
Right.
Pretty large. Our typical leases being 4,000 or 5,000 feet, that was a large one. It did have that effect, as Kris Douglas described.
Okay. Todd , your commentary basically around the market and the difference in pricing for public and private REIT. How do you think that affects your acquisition pace going forward? You have already cut that down a bit. What would you have to see change for you to open it up a bit more?
I think, the good news is, as Rob went through, we certainly found a nice group of acquisitions that yielded above our average implied cap rate. I think we're confident and comfortable that we can produce, as we said, up to $125 million this year of acquisitions that can still be in that 5.5%-6% range, so they're accretive. I think to your question, if we were going to turn that up, clearly we would need to see a continuation of sort of the improvement in stock price and implied cap rate for us to really see that turn up. I mentioned about a 50 basis point or more gap between where we are at 5%, 6%, mid-5% level and sort of the broader market for some larger transactions being closer to 5%, kind of ±5%.
You could certainly argue either side of that. It could even be more than 50 basis points. I think as we see our implied cap rate move to the low 5%s, it certainly opens it up for us and allows us to kind of expand our view of what we can do. Whether we can do that this year obviously remains to be seen. Obviously, we'll reevaluate that as we go into 2019. Certainly seems like we're headed in a better direction a quarter later.
All right. Thanks a lot.
Thank you.
The next question is from John Kim of BMO Capital Markets. Please go ahead.
Thank you. The occupancy in your multi-tenant portfolio, which remains very steady at 88%. That still seems a little low, just given the demand for outpatient care and the strong economy. Is this basically the price of doing business on-campus multi-tenant, or is there anything that you could do to drive this figure above 90%?
Sure. I think long term, John, we will continue to drive it towards that 90% level. I do think you're right that if you were able to parse out other folks' portfolios that were true multi-tenant, mostly on campus, you would find a very similar number. I think if you look at some folks out there, whether it's HCP or Ventas, who may have more of that maybe than our direct peers, you'll find that. Even, as we've said this before, if you look at HTA and you kind of parse out their multi-tenant versus single tenant from their disclosure, you'll find it's not too dissimilar. It's that same 88, 89 level.
Long term, though, certainly we look to see getting absorption, and some of that is lease up, but some of it is continuing to manage the portfolio and culling those properties that may be just lagging and stuck and not able to generate as much absorption. I think 90 is certainly a goal in our mind over time. It's not going to happen overnight, but as we've said, 20, 30 basis points a year of absorption is a realistic pace.
Even in that scenario, 90% is as good as it gets? Could it ever get up to 95+?
It's going to be very dependent upon the composition of the portfolio. I think if you're just saying, "Hey, what is an on-campus multi-tenant MOB typically run?" In a broader portfolio of 150, 200 properties, you're going to get closer to that 90%. It's not to say you can't have a building that's 100% or 95%. It's just that when you look across a broader universe, I think you're going to be closer to that 90%. A lot of it's just this functional turn that you have. As we've described, there's a lot more activity when you have a multi-tenant building of coming, going, so you get this sort of more frictional vacancy.
Over time, as the building has been around a while, you can be left with some smaller spots that are more challenging to lease, and you're sort of waiting for a tenant who is adjacent to that space to expand and take it. With all of that across 200 buildings, you tend to be closer to that 90% level.
Okay, on your general acquisitions this quarter, can you discuss the cap rate differential between the office and MOB assets that seem like they're almost identical assets? I realize occupancy is part of that, but still, it's a pretty wide gap between those two cap rates.
Yeah. There was two buildings there adjacent to St. Anthony's Hospital there where we have other investments. One of the buildings we classified as office. It's got general office tenancy in it. There was a difference in the value that we assigned to each of the buildings. That's primarily the difference between the two. The vacancy, obviously, in the one, the medical office building we see as having potential to lease up. There's currently some leasing activity that's out there right now that we think will bring it into the mid-80s on an occupancy level. Ultimately, when stabilized, it'll stabilize in that mid to high 6% level. There's some room to close that gap between the two, but there is a difference in the two buildings.
Same location, same tenant, same size.
Yeah, same location. These are two buildings. We think that there's probably some long-term redevelopment opportunity here as well. These two buildings sit on the same parcel of land, 13 acres of land, at the front door to the hospital. We think there's some long-term value there for redevelopment, which is really the attractive thing about these buildings.
John, I think the other piece to that is the office building with the higher cap rate. We have a large user in there that's actually looking to expand and take the balance of the space. We think they're committing longer term. We think it will remain office, frankly, until, as Rob said, down the road, it becomes a potential redevelopment play. We looked at that very differently in that that's going to remain office for some time, whereas the other building can continue to improve, as Rob said, financially as a leasing to medical tenants. We just put different valuations internally on that.
Okay. A couple of questions for Kris on the CapEx. I think you mentioned that there will be a TI reimbursement in a future period. How will that be recorded?
The cash will come in, and then we will just recognize the income. We'll get all the cash up front, and then we'll recognize that income on a straight-line basis over the term of the associated lease.
You also mentioned that there was higher maintenance CapEx because of some acquisition costs were deferred or acquisition CapEx was deferred. Can you just remind us how you define CapEx on acquisitions versus what you have-
Yeah
on your maintenance CapEx?
Yeah. What we do is when we are buying a property, a lot of times we will have acquisition capital, either TI or maintenance CapEx, that we will underwrite into the project. It'll be reflected in the cap rate that will show for the investment and our investment activity in the supplemental. That capital we look at is acquisition capital as opposed to maintenance CapEx because we've already kind of taken it into account in terms of that cap rate. What we do is that any of that capital that is spent in the first year or two goes into that acquisition capital. In the instances this quarter, just for various timing on some of the projects, it took longer than that year or two to get completed.
As a result, based off of the internal guidelines we've set up, it fell into maintenance CapEx as opposed to the acquisition capital. If it would've been done a quarter, maybe two quarters previous, it would've been in acquisition capital. That was the reason for pointing it out.
Maybe, John, also on that, it's partly related to our same-store principle of bringing assets into the same-store pool after eight quarters for a year-over-year comparison. Basically, that cutoff ends up being a two-year period. Once it goes in the same store, we say, "Hey, it's clearly maintenance CapEx." That's kind of what happened this quarter.
Okay. Thanks for the clarity.
Sure.
The next question is from Richard Anderson of Mizuho Securities. Please go ahead.
Thanks. Good morning, everybody.
Good morning.
Let's say the acquisition environment continues along these lines, and perhaps you're still not quite ready to raise conventional equity. Given the match between dispositions and acquisitions using that kind of math, would you be more inclined to be a buyer of sort of the value-add type of product, and sort of juice returns over the course of the coming year or so? Are you more inclined to take more the safer route and sort of fully occupied assets?
I think you've seen us over time do a little of both. I think value add and medical is a pretty safe bet in terms of value add. It is not higher risk like you might traditionally think. To your point, some of that is what Rob Hull was just describing with the two properties in Denver. The occupancy clearly being in the 80s is certainly kind of value add, if you will, in the medical office play, and as Rob Hull said, long term, we see redevelopment opportunity there. Or just with 13 acres of land, maybe we can add building and parking garage there as well. I'd say it is both. Clearly, our primary focus historically and going forward is buying quality stabilized assets.
We also have done a lot of work in the last couple of years, as Rob Hull said, with an eye towards building that development and redevelopment potential, which is a bit of a value add play, maybe a little twist on value add, where again, if you can buy them individually, as we have done this year and we did some of last year outside of the Atlanta deal, buying things little one and two at a time, where cap rates might be 5.5%-6% rather than 5% for a bigger portfolio.
Got you. Then-
A mix of that.
Okay. With your acquisition guidance of about $100 million, same for dispositions, but you talked about the possibility of joint venture creations, whether it is internal with your assets or buying external from you at this point. I am curious, what kind of size would it require for you to go the JV route, since at the present time, you are assuming sort of dispositions fund acquisitions?
Well, I think just simple math would say, to your point, if we're selling $100 million plus or minus at the top end and buying that, if we saw something that became a little more sizable than that, whether it was just one asset that kind of pushed us well over that limit or it was a portfolio we liked that said, "Hey, this is $100 million on top of what we can normally do, maybe we need to look at that." I think also you have to consider if you're JV-ing with somebody and starting a relationship in that manner, you probably aren't going to do it on one small asset. It might be something that is $100 million or greater, I think, to answer your question.
Okay. The magic number is $100 million, perhaps. Not to hold you to that.
Sure. Sure.
Okay. That's all I got. Thanks.
Sure. Thanks, Rich.
The next question is from Omotayo Okusanya of Jefferies. Please go ahead.
Hi. Yes. Good morning. Most of my questions have been answered, but I just wanted to focus a little bit on the CMS proposals put out last week. I know you made some initial commentary around it during the call. Just curious specifically if that changes your perception, or if you think any of those rules would change investor perception about cap rate differentials between off-campus and on-campus, whether they should start to expand out again, or whether you just kind of think it's more par for the course, investors are not going to look at any of this news as being material in any way.
Yeah. I think, Tayo, it's interesting always to watch some of those incremental changes that they make. I think certainly, some of the tweaks they made continue to really emphasize this site-neutral initiative that they have. Really, it's something that they were trying to do back in 2015 when they passed this whole Section 603 piece. I think what you're seeing now with these proposals and then the actual rules is just continuing to enforce that and try to curb anybody who's trying to sort of take advantage of that, because they were really serious about saying, "Hey, when a hospital department goes off-campus, there's really no logic to charging higher rates." I think it's just continuing to implement that. It's not surprising. I don't think it's a huge shift.
I think for us, it simply points us back to the campus and where we know it's very safe and critical for those services. Whether they go to site-neutral everywhere on campus or not, we think, broadly speaking, outpatient is a huge part of the solution to driving lower healthcare costs, improving outcomes. That's going to help, obviously on-campus where we think it's safer, and it's even going to help off-campus as well. On the margin, we like the on-campus safety. I think to your question about cap rates, I don't know if it's a big enough incremental change this time to suddenly suggest a big shift in cap rates. I think we have a very biased view based on our long experience that it should be a significant difference.
Whether everybody else reads that, I think it has to play out a little bit more over time.
Got you. Do you think you could ever get to the world where everything is just site-neutral?
Sure. I think CMS has a mindset of looking at that over time. Whether they go to that on the campus, that's hard to know. It's certainly a broader initiative and certainly helps at the margin, bringing down the cost of care. It could happen, but we think the reasons to be on campus have a lot more to do than just those arbitrage of reimbursement levels. There's clearly compelling reasons for surgeons, OB, all kinds of specialists that truly need to be near their ORs, their patient beds, all the different services they provide that are hospital-based. There's only more pressure growing on these physicians to be more productive, waste less time. Getting in the car and going off-campus for those folks just isn't really in the picture.
Got you. All right. That's helpful. Thank you.
Thanks, Tayo.
The next question is from Daniel Bernstein of Capital One. Please go ahead.
Hi, good morning.
Good morning.
I just wanted to ask, you put in this WALT, the weighted average lease term. I just want to make sure, is that just for the quarterly renewals, and new leases, or was that for the total portfolio? It seemed like it stretched out a little bit, and so I just wanted to understand if we're seeing some changes in how tenants are looking in terms of that lease term, and if that's impacting the TI CapEx as well.
Yeah. We actually show it in two different places, Dan, so I just want to be very clear.
Right.
On page 10 of the supplemental, when we talk about our leasing commitments and the WALT there, that is related to the renewals that are in place.
For the quarter.
For the quarter.
For the quarter. Okay.
Yes. As I mentioned, inside of those renewals, we had a 47,000 sq ft deal that we gave a little bit more TI. It also had a longer term, 10-12 years. I cannot remember exactly which one. We also had two single-tenant net leases in there, which are longer in term. Those were 10-year deals. When you exclude those three and get back to your kind of standard multi-tenant, which is what you are comparing across those other five periods on that page, the term, I think, was 41-42 months. Pretty much in line with what we have seen historically.
Okay. No change in trend there. The other question I had, I just want to follow up on kind of like Rich's question on value-add versus A assets. Have you seen any changes in pricing or the spread between, say, value add, B assets, A assets, that would make you lean one way or the other, or is the competition spread kind of limiting the ability to find value or B-ish assets? Maybe you do not want those either, in some ways. Is the spread between A and B assets kind of really thin at this point, or is it widening out? Just trying to think about the direction of that.
I would say it has gotten tighter, certainly in the last 12-24 months, and that certainly reflects a lot of the capital that has come into the space. I think the public MOB REITs have generally erred towards certainly the higher quality side of that, certainly in the last two years. I think the privates have certainly come in and struggled with the fact that to get a little better returns, do they need to go up the or out on the quality scale. I think they have been chasing some of those things that I would say are B, A versus B. B is probably compressed a little to the A.
I think there is sort of A and B, as you described, which may be from five to six, There is everything else that probably there is a kind of more of a traditional gap for some of the things that we certainly would not be looking at or chasing. Privates are still playing at it, but probably not as aggressively, and they are not in scale. There is probably still some gapping out where you can get things that are six all the way up to eight if you are willing to go out on the risk curve. I guess going forward, I could see it basically staying pretty compressed where it is, just given all the private capital. Yeah. Same would go maybe for primary versus secondary markets as well. There is really, that gap has come in a lot. Yeah, I think that is right.
I think the same sort of logic applies to primary markets versus the secondary markets. As Todd said, there's a lot of capital out there chasing these deals and those guys that we're looking at maybe buying something in the six cap, six and a half cap range are having to drop down a little bit and get a little more aggressive on what they would normally be buying, but paying a lot more for it.
All right. Sounds good. Thank you for taking my questions.
Sure. Thanks, Dan. Welcome back, by the way.
Yes, thank you.
Again, if you have a question, please press star then one. The next question is from Eric Fleming of SunTrust. Please go ahead.
I'm just wondering if the market stays compressed on the cap rate side through the end of 2018, I know you guys have talked about around the edges, you'll do dispositions, but if you keep these aggressive cap rates, would you guys be willing to dig a lot deeper around your portfolio and sell some stuff that might not be non-core, but it's kind of capped out in terms of where it's the opportunity for you guys?
I think we would see that as the normal course for us. I think somebody else asked, what do you have that's not growing at three? That's one way to look at it. There's also just saying, okay, now that our average is around three, maybe the question isn't what's below three, what is it that maybe isn't growing or set to grow well above three for some time? We'll look at that. I don't think we're looking to ramp that up in a huge way. I don't think there's a huge need to demonstrate some kind of pricing or mark. There's a lot of that out there. I don't know that that's the benefit.
I think more for us, it's about looking at the trajectory of each of these assets and kind of where they're headed and just managing that, just continually trying to improve that and the stability of that and the steadiness of it. I don't think it's a huge acceleration, but obviously, if we saw some things that made sense that we could put in a JV or just sell it outright and it was time for us to rotate out of those assets and buy something else, certainly we'll look at it. I don't foresee us doing that in a massive way relative to the portfolio.
Okay, thanks.
Sure.
This concludes our question and answer session. I would like to turn the conference back over to Todd Meredith for closing remarks.
Okay. Thank you. We appreciate everybody joining us this morning. We will be around here if anybody has any follow-up. Thank you. Everybody have a great day. Thanks.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.