Healthcare Realty Hit By A Difficult Macroenvironment (NYSE:HR)

Investment Thesis

Healthcare Realty Trust Inc. (NYSE:HR) is a real estate investment trust “REIT” focused on owning and leasing healthcare-related properties. As a REIT, the company is required to distribute 90% of its taxable income to shareholders in the form of a dividend, offering an attractive option for income-oriented investors. Despite its defensive nature, stable cash flows, and dividend, HR shares delivered significant losses in the past twelve months, with its ticker falling by 27% during the period.

Despite recent price correction, I believe that HR shares have still more downside potential, given the challenging macro-economic environment, hawkish Fed monetary policy outlook, high-interest rate environment slowing property development projects, and low probability of near-term revenue growth as management will remain focused on absorbing newly-acquired assets from its merger with Healthcare Realty Trust of America (HRA) for the next 12 to 18 months on the least.

Challenging Macroeconomic Environment

REITs are susceptible to fluctuations in interest rates, which impact the cost of borrowing and eventually impair financial performance. The ability of REITs such as HR to undertake new development projects or acquire other businesses is impeded by a rise in interest rates because of the higher cost of borrowing needed to fund their operations and investments.

The company’s interest rate expense stands at $260 million on $5.4 billion debt accumulated in the past few years, most of which are senior notes with fixed interest with an average effective rate of 4.4%. As these notes mature, HR will find itself refinancing in a higher interest-rate environment, possibly uneconomical for a company whose cap rate on its properties falls around 5%. Management states in SEC filings that they don’t plan to retire existing debt, planning on refinancing. Maintaining profitability in a higher-for-longer interest rate scenario seems to be predicated on the company’s ability to raise the rent, which won’t be easy for challenged tenants grappling with the labor shortage, wage, and material inflation, and regulatory efforts to rein in national healthcare spending, hindering a much-needed recovery after COVID disruptions led to a significant decline in elective and non-emergency procedures, a critical source of revenue for healthcare providers, especially HR’s tenants, who are mainly small and medium outpatient healthcare providers.

Beyond operational challenges, rising interest rates make other investments more attractive to investors, which can lead to a decline in demand for REITs. This, in turn, can result in a decrease in share price as investors sell off their holdings or move their money into other investments. One-year treasury bonds currently yield 5.5% interest, which is comparable to HR’s dividend yield of 6.5% at the time of this writing. Those betting on a share price rebound will have to justify the delta between HR and risk-free yield, and at this point, the growth argument is considered weak.

Revenue and Dividend

HR recently merged with Healthcare Realty Trust of America to form an even larger healthcare real estate company with an impressive footprint across the United States. Overall, HR has shown a general upward trend in revenue over the past few years as a result of developing and acquiring assets. Nonetheless, investors are yet to see meaningful benefits from the company’s revenue growth as FFO and AFFO per share struggle to maintain an upward trend.

The revenue drivers of HR are primarily related to the rental income it generates from its healthcare-related properties, namely rental income from office buildings and outpatient facilities, and smaller healthcare clinics, as opposed to larger hospital real estate assets found in other medical REITs such as Medical Properties Trust (MPW). Lease renewals and occupancy rates are critical factors determining profitability. Given its focus on smaller physician groups and related healthcare businesses with limited financial resources, occupancy rates and turnover rates are lower than that of MPW. For example, MPW has an occupancy rate of 99% on 440 properties with 55 million square feet of space, compared to HR’s 88% occupancy rate on 686 properties with 40 million square feet of space.

Only 6% of HR’s portfolio is tied to inflation-based escalators, making it more susceptible to the adverse impacts of inflation. This is a critical weakness because, unlike MPW, which generally offers triple-net leases, HR is often required to assume maintenance services of its properties, leaving its operating expenses unhedged against rising costs. HR has an AFFO margin of about 50% – 55% compared to 60% – 65% for MPW.

HR’s normalized FFO run rate, which forms the basis of shareholders’ dividend returns, stands at $520 million, adjusted for depreciation, amortization, and one-time costs related to the recent acquisition. Historically, the company distributed 75% to 80% of normalized FFO as a dividend. Assuming a continuation of these dynamics, one should expect HR to distribute $390 million to $415 million in 2023, which translates to $1 – $1.1 per share, yielding 5.2% – 5.7% based on the current share price of $19.2 per share.

Summary

HR has delivered strong financial results over the years, with steady revenue growth, acceptable occupancy rates, and relatively stable dividend payments to shareholders, thanks to a diversified portfolio across various healthcare sectors, helping mitigate concentration risk and generate stable cash flows.

Demographic headwinds manifested in the aging population bode well for the demand for healthcare and healthcare real estate. The company has a solid balance sheet with moderate leverage, opening an opportunity for future growth in the long term.

In the short and medium run, shares are unlikely to recover from their losses due to a challenging microenvironment, manifested in a hawkish Fed monetary outlook, decreasing the appeal of REITs as an asset class. Despite its dry powder, I don’t expect large acquisitions in the near term, as management continues its focus on absorbing the assets inherent from the HTA merger last year. These dynamics underpin our hold rating for HR.