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Good morning and welcome to the HCP, Inc. Third Quarter Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded.
I would now like to turn the conference over to Andrew Johns, Vice President, Finance and Investor Relations. Please go ahead.
Thank you and welcome to HCP's third quarter financial results conference call. Today's conference call will contain certain forward-looking statements. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, our forward-looking statements are subject to risk and uncertainties that may cause actual results to differ materially from our expectations.
A discussion of risk and risk factors is included in our press release and detailed in our filings with the SEC. We do not undertake any duty to update any forward-looking statements. Certain non-GAAP financial measures will be discussed on today's call. In an exhibit of the 8-K we furnished today with the SEC, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measures in accordance with Reg G requirements. The exhibit is also available on our website at www.hcpi.com.
I will now turn the call over to our President and Chief Executive Officer, Tom Herzog.
Thanks, Andrew, and good morning, everyone. With me today are Pete Scott, our Chief Financial Officer; and Scott Brinker, our Chief Investment Officer. Also here and available for the Q&A portion of the call are Tom Klaritch, our Chief Operating Officer; and Troy McHenry, our General Counsel.
Let me start by saying, the last two years have been a whirlwind of activity, during which we have fully restructured the company and set forth a clear strategy. The HCP of today is very recognizable from the HCP of just a couple of years ago.
Including the announcement of the Shoreline transaction today, we sold, spun or transitioned over $12 billion of non-core assets. We repaid $5.7 billion of debt. We reduced our Brookdale concentration from 35% to 17% of NOI. We expanded our development and redevelopment pipelines. We recruited and installed an entirely new C Suite and we refreshed our board. These actions have resulted in a vastly improved portfolio and balance sheet with a cohesive and energized team.
So, let me describe how I see the current state of play, starting with the challenges. First, senior housing new supply has been a headwind for HCP and the entire sector. However, we are confident, senior housing will be a strong business over time within HCP's balanced and diversified portfolio of private pay healthcare real estate.
Second, the transitions from Brookdale to new operators have been painful and performance declined significantly prior to the replacement operators assuming control. The reduced occupancy impact will carry forward through at least the first half of 2019.
Fortunately, the vast majority of the transitions are complete and we are finally seeing stabilization. We remain confident that in the hands of new and engaged operators, we will recapture a significant upside to this group of communities over time.
Finally, this year's capital recycling and redevelopment activities will lean on our 2019 earnings growth as we earn in the dilution from completed sales and experience temporary downtime of properties undergoing redevelopment.
Next, what's going well. First, our 82% on-campus medical office portfolio remained consistent and stable. We're also benefiting from our decade-long relationship with HCA through the devolvement program we announced today.
Second, our life science business is performing exceptionally well and we continue to see significant demand from growing tenants.
Third, our current $800 million development pipeline is on time, on budget, fully funded and already 83% pre-leased. With the strong momentum and strength in the market, we're evaluating the acceleration of certain projects such as the additional phases of The Shore at Sierra Point. In addition to the cash flow and earnings, these projects will produce beginning in 2019 and accelerating in 2020 and 2021, we expect to realize significant NAV creation for our shareholders.
We expect to deliver stabilized returns in the 7% to 8% range which compares to the corresponding market cap rates of about 5%.
Finally, we took advantage of robust pricing in the market and the like what we believe to be significant value for shareholders by monetizing our Shoreline Technology Center in Mountain View. This transaction will dramatically reduce leverage and position us with BBB+ credit metrics, support our value creating development pipeline, and provide us funding to support approximately $400 million of accretive acquisitions, which we believe will represent $0.02 to $0.03 per share of FFO and FAD accretion once fully invested. As you can tell, we have positive momentum and this is a very exciting time for HCP.
With that, I'll turn it over to Pete to discuss our financial performance for the quarter and outlook for the remainder of the year. Pete?
Thanks, Tom. Today I will start with a review of our results for the quarter and update on the balance sheet as a result of the Shoreline Technology transaction and, finally, provide an update to our guidance for the remainder of the year.
Starting with our third quarter results, we reported FFO as adjusted of $0.44 per share and our portfolio delivered 1.7% year-over-year same-store cash NOI growth, which was in line with our expectation.
Let me provide more details around our major segments. For medical office, same-store cash NOI grew 2.3% over the prior year, driven primarily by in-place lease escalators. We continue to see strong tenant demand for medical office buildings. Our retention rate for the year is over 78% and we had a positive rent mark-to-market on our renewals of 4%.
Same-store cash NOI in our other property segment, which is primarily our small hospital portfolio, grew 6.5% over the prior-year period. This result was driven by strong performance at our Medical City Dallas campus, where our lease structure allows HCP to share in the expansion and success of the hospital, which is performing at a high level.
As a reminder, Medical City Dallas is one of the leading medical campuses in the entire country. The fully integrated, 2 million square foot campus includes an 800-bed hospital operated by HCA in over 750,000 square feet of on-campus medical office space. This is truly a trophy campus within our medical office and hospital portfolio.
For life science, third quarter same-store cash NOI grew 2.6% over the prior year, driven by contractual rent escalators and positive mark-to-market on rents. Excluding the impact of the mark-to-market of the Rigel lease, which we have discussed on prior calls, life science same-store cash NOI growth would have been approximately 5.5%.
From a development leasing perspective within life sciences, we continue to make incredible progress and have significantly de-risked our active development pipeline. During the quarter, we signed a lease with Global Blood Therapeutics for the entire 164,000 square feet of Phase IV at The Cove. GBT is a rapidly growing publicly traded biotech company focused on developing treatments for blood-based disorders. We are now 100% pre-leased across the entire 488,000 square feet of remaining in-process development at The Cove.
At The Shore at Sierra Point, our other major South San Francisco development project, we are pleased to announce that we have executed leases with MyoKardia and a high quality pharma company, and now have the entire 222,000 square feet of Phase I pre-lease. Our leasing progress at The Shore is well ahead of expectations and we are benefiting from the strength and momentum we see in the South San Francisco life science market.
For our senior housing triple-net portfolio, year-over-year same-store cash NOI grew 1.6% in the third quarter. This was in line with our expectations and takes into account the previously announced rent adjustment with Brookdale. On a normalized basis, same-store cash NOI growth in senior housing triple-net would have been approximately 3.5%.
And finally, our SHOP portfolio. Same-store cash NOI for the quarter was negative 6.3%. As we discussed last quarter, there continues to be a significant disparity in the performance between our core portfolio which grew a positive 4.1% during the quarter and the assets we plan to transition or sell which declined 25%.
Scott will provide an update on our operator transitions and additional color on the performance of our senior housing portfolio momentarily.
Turning now to the balance sheet, we have significantly improved our balance sheet and credit profile as a result of the $1 billion Shoreline transaction. Initially, we planned to use the net proceeds from the sale that we pay $450 million of bond and $224 million of term loan debt.
The balance of the net proceeds or approximately $315 million will be used to reduce our line of credit. The blended rate across the debt we intend to repay is at an average interest rate of 3.5%. With the repayment of debt, our net debt to adjusted EBITDA will be reduced down to the mid-5 times range, or nearly a full-term from the 6.5 times we reported at the end of the third quarter.
As Tom stated, it is our expectation that during 2019 we will redeploy a portion of this balance sheet capacity into select strategic acquisitions and to fund our accretive development and redevelopment pipelines.
Importantly, we expect our net debt to adjusted EBITDA to settle in the high-5 times range on a run rate basis after incorporating the reinvestment of this capital. Of note, this sale will utilize the remaining tax loss carry-forward we crystallized as part of that QCP spin-off in late 2016.
Turning to the dividend, on October 25, our board of directors declared a quarterly cash dividend of $0.37 per share. We expect our dividend to remain fully covered in the mid-90% range in the near-term. Over time, we expect the payout ratio to decline with the significant earning benefit from our development pipeline, our in-place lease escalators which average approximately 2.75%, a positive mark-to-market opportunity in our life science segment, and the future upside opportunity from our senior housing transition portfolio.
Finishing now with our full year guidance, we are maintaining our FFO as adjusted guidance in the range of $1.79 to $1.83 per share and also reaffirming our aggregate SPP guidance range of 0.25% to 1.75%. By segment: life science and other are trending towards the high-end of our ranges; medical office and triple-net are trending towards the middle; and SHOP is currently trending towards the low-end of the range. Additional details of our guidance, along with timing and pricing related to our capital recycling, can be found on page 46 of our supplemental.
With that, I would like to turn the call over to Scott.
All right. Thanks, Pete. I'd like to expand on the capital allocation theme. There has been significant activity, most recently the announced sale of the Shoreline campus for $1 billion. In August, we closed the $600 million medical office joint venture with Morgan Stanley. That trade diversified our markets, improved our on-campus percentage, and added an A-rated tenant with whom we'll grow. We also captured a 200 basis point spread in yield, so the outcome was accretive both strategically and financially.
Also in August, we sold a dated off-campus MOB for $20 million at a cap rate in the high-3s. The site will be redeveloped for multifamily, so we capitalized on an aggressive buyer to exit a non-core property at a highly attractive price. Those proceeds can now be redeployed into a $26 million on-campus development that we recently started in Myrtle Beach. The 90,000 square foot MOB will be anchored by HCA, a best-in-class health system. Stabilized yield was in the low-7s, and we have a unique opportunity to do additional on-campus development with this long-standing partner.
Moving to life science, in addition to exceeding expectations on our highly profitable $800 million development pipeline, we're active on a few potential acquisitions in our core markets. These are strategic projects and include stabilized cash flow, value-add and densification opportunities, allowing us to use our platform and expertise to create value. Each acquisition would be an accretive use of proceeds from the sale of the Shoreline campus.
We continue to make rapid progress in remaking our senior housing portfolio and platform. In the last two years, we've improved our diversification and asset quality by selling or transitioning more than 200 Brookdale properties, totaling $3.5 billion of asset value.
This massive undertaking with Brookdale is now very, very close to the finish line. We may seek to further reduce the concentration over time, but we're now in a position to do so opportunistically. We also began the redevelopment of eight senior housing properties this year, with total spend of $70 million. The majority are transition assets where substantial upside exists with a revised physical plant and a more focused operator.
Redevelopment is an important part of our initiative to modernize the portfolio. We expect low-double-digit returns on cost, but the financial benefit takes up to two years given the redevelopment time line followed by lease-up.
Moving to senior housing operating performance, results in the core portfolio have been strong at positive 3.3% NOI growth year-to-date. Occupancy and margin are essentially flat from the prior year and rates are up 4%. We're very pleased with that performance, given the environment. The 39 operator transitions are now 90% complete and the final 4 should be done in the next month or two. 19 of those transition properties were formerly triple-net, so they're not included in the same-store results, but their performance has been poor and underlying NOI is now below the rent payment that we had been receiving. This will likely result in a loss of $0.01 to $0.02 per share next year. We expect to eventually recapture this lost income through improved operations.
We're pleased to report that occupancy in the transition portfolio increased the past two months, particularly in the first wave of properties that transitioned back in March and April. This highlights the upside waiting to be recaptured and confirms that the turnaround doesn't happen overnight. So, we continue to expect negative year-over-year NOI results in that transition portfolio likely until late 2019 when we do a full lap around the trough in occupancy.
Importantly, from where the transition assets sit today, there's up to $25 million of NOI upside simply from recapturing lost occupancy and eliminating the transitory expenses we incurred in 2018. There's additional upside from driving rate, which is certainly possible given the higher service levels now in place.
I'll now turn the call back to the operator for Q&A.
Thank you. Our first question today will come from Smedes Rose of Citi. Please go ahead.
Hey. It's Michael Bilerman here with Smedes. Just sticking, Scott, with the SHOP portfolio and the transition assets, I was wondering if you look at the sup page 31 and 33, especially given your commentary around the negative impact this year and the eventual potential of upwards of $25 million of additional NOI, can you start breaking out all of the assets between transitioned and the remaining same-store pool, so that we can clearly sort of understand what's happening in the core assets versus the transition assets, is that something you think you'd be able to provide?
Hey, Michael, it's Scott. Certainly happy to look into it. We did break out the amount of NOI from each of those two categories, as well as the growth rate. In NOI, are you looking for, like, occupancy or revenue...
Yeah. What I would say is the table on page 33 is basically having the history, so that we can actually see the trends where it was, where it went to, and where it may go in the future, and just trying to get a little bit more granular other than just a one-quarter look at just the NOI number, because clearly, this is a big revenue issue, and you're also spending more money, so understanding those two things, on how they relate to each other, just given the impact that it's having and then potential upside would be helpful. I don't know if there's more of a comment than a question, but...
Yeah. That's good. So, let us – looking at that, Michael, for now I'll actually – I'll just give you the results for this quarter on occupancy. The core portfolio was modestly higher year-over-year, and that transition portfolio was down 400 basis points year-over-year, and there's a huge difference in margin as well.
The core portfolio is in the low-30s, which is still, I think, low versus where it could get in a more normal environment, but the transition portfolio is in the mid-20s from a margin standpoint. So, it probably would make sense to provide even more detail on those two portfolios given how differently they're performing.
Tom, do you want add anything?
Michael, it's Herzog. Yeah, I think we can add that next quarter. It's a good point.
Okay. And then, you mentioned the assets that were triple-net that went to SHOP, and I think you said those are – the NOI that's coming out is below what the net rent was. Where does that show up in terms of differential, and what was that differential in the quarter?
Yeah. Hey, Michael. It's Pete here. How're you doing? As Scott mentioned, we transitioned these assets over the course of the year. There's actually 19 assets that are transitioned from triple-net into SHOP. They are not in the SPP pool, which is why we wanted to point out that there is a roll-down. We have transitioned these assets throughout the course of the year. We received rent for a part of the year. The roll-down is somewhere between $0.01 to $0.02, as Scott mentioned. Now, the good news is that, different than traditional capital recycling, we think that we will recoup these lost earnings. It just will take time. So, that's why we included the $0.01 to $0.02 in the remarks today.
And then, you're saying the $0.01 to $0.02 is a annual 2019, annual 2018, I'm just trying to put that into context and where we can actually grab that type of impact out of the sup.
Yeah. It's not in the sup, which is why we wanted to talk about it, Michael. It's not a huge dollar amount. There's only $10 million to $12 million of NOI from those properties. But the rents that we had been paying was $5 million to $7 million higher than that. So, that's why when that converts into SHOP, there is a roll-down to impact us more in 2019. And the performance is really falling off quite precipitously and which is why we wanted to raise it.
Okay. Thanks.
Our next question will come from Juan Sanabria of Bank of America. Please go ahead.
I just wanted to follow-up quickly, I guess, on Michael's question on the $0.01 to $0.02 drag from that conversion from triple-net to RIDEA. Is that net hit in the third quarter numbers or that will be incremental from a go-forward perspective from the third quarter into the fourth quarter?
Yeah. Most of it occurred this quarter because we transitioned the vast majority of these assets in the second quarter, although some of it did happen over the third quarter. There will be a slight roll down into the fourth quarter. But the big chunk occurred in the second quarter already, Juan.
Okay, great. And then just bigger picture, I mean, it sounds like you guys are talking about a bit of a drag incrementally from triple-net to RIDEA, as well as from temporarily getting some proceeds before you can put it to work. Should we think of earnings growth or normalized FFO growth in 2019 on a year- over-year basis or do you think there's a risk that numbers will come down? I know you're not wanting to give guidance as of yet, but particularly just given the dividend, is – should earnings grow next year and will the dividend coverage improve or not necessarily?
Yeah. It's a good question, Juan. Let me tell you how I look at it. It's Pete here. If you think about the implied fourth quarter FFO as adjusted, when you look at what we've reported and then compare it to the midpoint of our guidance, if you annualize that, you'll get to a reasonable starting point as you look at 2019 versus 2018, and you would also have to factor in natural growth that we see within our portfolio from an SPP perspective, plus some development and redevelopment earn-ins, we'll start to see some benefits next year as some of the projects that we've been working on, specifically The Cove worked their way into our earnings. And then, we'll see actually a bigger ramp-up in 2020 and 2021 from some of the other projects we talked about today. And then, obviously, the Shoreline accretion as well is something else that, we talked about $0.02 to $0.03 of accretion from that transaction which is one rate accretion. So, the amount that we can get in 2019 will depend upon how quickly we can put some of that dry powder to work.
And then, lastly, Scott did mention the upside opportunity in the transition portfolio that we spent some time talking about today. So, that's the way we look at 2018 headed into 2019. We'll obviously provide much more detail on it in our fourth quarter earnings call.
Okay. If you'd allow me just one more question. On the HCA new relationship, is there any potential size of the opportunity to quantify in terms of new developments you could do with on-campus MOBs and is that 7% yield kind of a good benchmark to think about that opportunity set?
Yeah. Hi, this is Tom Klaritch, Juan. Yeah, the low-7 – low- to mid-7 returns is what we're targeting in each of these projects. There are a number of projects where we're looking at right now. I would guess we'll probably be in kind of the $70 million to $100 million per year for the next couple of years with it.
Thank you.
But it could go higher from that as well, probably.
We'll continue to find additional MOBs as the program moves forward.
Yeah.
Our next question will come from Rich Anderson of Mizuho Securities. Please go ahead.
Thanks. You said the – I guess, I missed this. The Shoreline is accretive, meaning that the cap rate is below the 3.5% average interest rate on the pay-down. Is that right?
Yeah. So, here's the way we think about it, Rich. That's a good question. Initially, we will take the $1 billion of proceeds which is a 3.5 cap rate and we will repay approximately $1 billion of debt. And the blended interest rate on that debt is 3.5%.
Okay.
However, that would take our leverage into the mid-5s, which is where we expect to report at the end of the year. We are comfortable taking the leverage up into the high-5s, which is what we've been talking about to the Street. So, we have about $400 million of dry powder for acquisitions, which we would expect to put to work accretively, and that's the $0.02 to $0.03 that...
Got you, got you. Thank you. And then...
And Rich, that's on a run rate basis, once it's invested, just to be clear.
Say that again, Tom.
That's on a run rate basis once it's invested, just to be clear.
Oh, yeah, of course. Yeah, yeah.
Yeah.
On the performance of the core portfolio, 4.1%, it was a two – you had a two-handle positive on it last quarter. That 4% doesn't sound very repeatable to me. I'm glad it's doing better than the transition portfolio, of course. But is there something about the elevated nature of the performance in the core portfolio last quarter and, again, even more so this quarter, that we should sort of just be a little bit more sober on?
Hey, Rich. It's Scott. Yeah, it's a small pool.
Yeah.
It's 32 properties. When we reported last quarter at plus 2.9%, I thought that would be the high point for the year, then we report plus 4.1% this quarter. So, that's now the high point for the year. I don't think that that will repeat in 4Q 2018. That being said, there are some real positives about that portfolio. There's a number of assets in Florida that we spoke to last quarter that Sonata took over from Brookdale, and that's been a big part of the improvement in year-over-year growth this year. And then, there's a portfolio that we acquired a couple of years ago, put in a new operator, invested some money into the physical plants, and that's really paid off with higher occupancy and higher rates. So, there are things happening in that core portfolio that were temporary, but nice boost to 2018 results, that I think 4.1% is a little bit unusual and anomalous for this market. But we're happy to have reported it.
Okay. Got you. And just one quick one, Pete. Can you quantify new lease accounting for 2019? How meaningful it is to you at this point?
Yeah. Good question, Rich. Overall, we do not expect lease accounting standard to have a significant impact for us. We're still finalizing our adoption, but it's probably around $0.005 hit to NAREIT FFO in 2019, with relatively little impact beyond that. We'll talk more about it next call when we can have our guidance, but that's how we're looking at it right now.
Thanks. Appreciate it.
Thanks, Rich.
Our next question will come from Chad Vanacore of Stifel. Please go ahead.
Hey, there. I want to attack the other side of the SHOP portfolio from what you – you gave us some core numbers, but SHOP NOI growth run rate seems to fall below your state of range of down 4% to flat in guidance. Are you expecting a bump in 4Q and would that be from the transitional side of the portfolio?
I'd say we're expecting a bump in 4Q. Year-to-date the SPP portfolio. Chad, we're negative 3.3%. So, it's right inside the guidance range. We're not expecting 4Q to be better necessarily. We're still in the midst of the temporary impact from these transitions, so I wouldn't be surprised if that's – that number is down quite a bit again in 4Q...
Okay.
...portfolio.
And then, how should we think about that SHOP trend into 2019? It seems like it would lag a bit in the first half of the year and maybe get better at the second half the year as comps get easier?
That's definitely the case for the transition portfolio, Chad. We talked about the upside of these assets, and that's from where we sit today, just absolute dollars of NOI.
But when we report, it's a year-over-year growth rate, and that's a much different analysis, just given where NOI was, where occupancy was four quarters ago. And the trough in occupancy was really in August. We've actually seen a nice bounce in September and October. So, that's a positive sign, but just given where the year-ago occupancy was, it's going to be until really late next year before we have a realistic chance to start showing year-over-year NOI growth even though the sequential growth should start improving before that.
All right. Any early signs so far into the fourth quarter with stabilization of those transition assets, I know you mentioned Sonata?
Yeah. Well, Sonata is one reason that our core portfolio has been so positive. Those were the assets that transferred over to them quite a while ago. But the transition portfolio is more Atria and Sunrise and Eclipse and Discovery. And it's really the group of properties that transferred earlier in the year that have had enough time to put in place a new team and systems and culture, and those are the ones that have started to improve. So, that's an encouraging sign that those early properties that transferred are now showing signs of why occupancy is moving higher. So, we're hoping and expecting that the balance will be the same.
All right. Maybe just one quick one. So, last quarter you reported 22 properties slated to be sold to Apollo. This quarter it looks like 19, what's the difference with three properties in that $50 million of proceeds you expected?
Yeah. There were three properties, Chad. It wasn't related to performance. They're actually doing just fine. But there was a management company that Apollo is using for the portfolio, had a non-compete restriction that we all thought would get waived, but didn't get waived. So, we ended up holding those three assets. Two, we've already found replacement operators, so we'll keep them. And the third, property is actively being marketed for sale.
All right. That's it for me. Thanks.
Thanks, Chad.
Our next question will come from Tayo Okusanya of Jefferies. Please go ahead.
Hi. Yes. Good morning over there in California.
Hi, Tayo.
For the – hi. For the SHOP assets that are in transition right now, could you just talk a little bit about what some of the things you're seeing that's kind of creating this pretty heavy impact on same-store NOI growth? I mean, I guess, transitions are always shaky and things happen, but I'm just kind of curious, like, what are you kind of seeing thematically that's kind of creating this kind of really big drag initially?
Yeah. Hey, Tayo, it's Scott. A couple of things to point out. The occupancy in those assets is down about 400 basis points year-over-year; and with a 25% operating margin, there's a pretty big multiplier effect on NOI, so that's a big part of it. Can we capture that over time, but for now, it creates a pretty depressed NOI.
And then, we also had a significant elevation in certain expenses that, we think, is more temporary, contract labor, over time, vacant positions that needed to be filled, a huge increase in repair and maintenance to get the properties back up to the right standard, and then some miscellaneous things that add up, like, insurance expense, it's about a tail insurance, bad debt that a lot of account written off at the transition.
So, a lot of things that are purely transitory that will go away, but we don't normalize for those things. I know some others do, but we just give you the number, and then we can try to talk through the different components. But those are the major categories, Tayo. It's just the occupancy, driven in large part by turnover. 50% of the EDs have been turned over. So, that puts additional pressure on occupancy and then just those expenses that are more one-time in nature.
Yeah. That's very helpful. With the triple-net portfolio, again, still some pressure on rent coverages, I'm just curious, should we be thinking about 2019 as a year where you may see even more transition to RIDEA in some of your clients like – in some of your tenants like Capital Senior Living or any others?
Tayo, we talked about transitioning some of the Sunrise properties to SHOP. Those are in the triple-net lease category today. They're a complicated waterfall structure that, I think, it makes sense to just go ahead and clean those up. And that's a material part of the NOI that shows up as being below 1.0 times in the supplement.
And it's important to note, there's really no earnings risk from converting those to SHOP, because the payment coverage that we report, the rents in the denominator is not the rents that they're paying us. You can think of those really as 1.0 time coverage leases. So, I think those probably will be converted, but there's no earnings risk on that conversion, which is, that's not the conclusion you would draw by looking at the supplement. So, I think it's important to note that.
The others with tighter coverage – I'm sorry. Go ahead.
Could you just explain that again why, again, in the sup it looks like it's less than 1 coverage. So, it seems like there should be some earnings dilution to converting.
Yeah.
While you're saying there shouldn't be.
Yeah. Exactly. It's a complex structure that we inherited when we acquired CNL more than 10 years ago. But the contractual rent that's due is a number that is higher than the rent they are actually paying us. And when we report the coverage in the supplement, we're reporting based on the contractual rent...
Contractual rent, okay. Got you. Okay. Helpful.
Our next question will come from John Kim of BMO Capital Markets. Please go ahead.
Good morning. I'm going to try a three-part first question on Shoreline. Did you originate the sale, or did the buyer, is that considered or was it considered non-core because it's essentially office? And can you describe who the buyer was as far as PE, pension fund, or some other kind of buyer?
Hey, John. I'll try and answer couple parts of the three-parter. The Shoreline campus is one that we acquired with Slough in 2007. And Slough actually had bought it from EOP back in 2005. At the time that we purchased it, there were more life science tenants within the campus. Over time, Google has taken over more and more of the space. They now occupy about 92% of the space.
So, it became more of a non-core suburban office asset for us that was a great piece of real estate to own, but to get the pricing that we got and to be able to recycle that capital into more of the core markets that we're in, made sense to us, and we're not disclosing the buyer. I know that was one of your questions. But I hope that I answered at least most of what you were looking for.
Well, maybe not the name of the buyer, but the kind of buyer they are?
Yeah, we're not going to get into those specific details on the purchaser, John.
Yeah. Okay. On page 27, one of your leases has like a 0.3% coverage around that area, and the footnote basically says it's because of developments that have not reached 80%, but on that coverage, it suggests that's well below 80% and I'm wondering if you could just comment on that scenario?
Sure. It's Scott speaking again. This is a small portfolio of three properties, obviously they're brand new that we acquired in January 2016, so about three years ago, acquired them well before they opened. There was a lease in place that we assumed, so the rent is relatively small, it's less than $4 million per year. So, these aren't material amounts. A couple of the – one of the buildings is leased up, the other two have not, but they are trending in the right direction.
So, remember, we report on a trailing 12-month basis and one quarter in arrears. So, the coverage isn't good, but the coverage today is much better than what we reported in the supplement. These are at least moving higher and these are good assets in, we think, good markets that over time should improve. So, this is not one that we're worried about. We're monitoring it, but we've got good credit behind it and a very long lease term.
That's helpful. Thank you.
Sure.
Our next question will come from Vikram Malhotra of Morgan Stanley. Please go ahead.
Thanks for taking the questions. Just on the balance sheet, the mid-5 leverage that you talked about, if you just fast-forward include all the EBITDA coming on from The Cove assume sort of no deployment from hereon, kind of where does leverage settle down?
Hey, Vikram. It's Pete. Good questions. Yeah, as we talked about, we see leverage settling in that high-5 times net-debt-to-EBITDA probably at the end of next year. And that assumes we redeploy the funds from Shoreline into fully funding our current active development pipeline, which is about $450 million plus some dry powder. And then, we'll get some benefit from some earlier Cove developments coming online, and we see ourselves settling out in the high-5s.
Now, would that get better, assuming your assumptions you talked about in 2020 and 2021, if we didn't do any more development? For sure, it would, because we've got a lot of developments for Phases III and IV of The Cove, as well as Phase I of The Shore at Sierra Point that come online in 2020 and 2021.
Okay. And then just redeploying, you talked about development, there are a bunch of different MOB portfolios out in the market, obviously, Landmark and CNL. Can you just talk about your appetite here for bigger MOB acquisitions?
Yeah. This is Tom Klaritch. We're always looking at the portfolios and, quite frankly, one-off MOBs that are out in the market. When you look at the ones that are out there right now, we look at the on- versus off-campus percentage, the tenant mix, the pricing expectations, markets, and we just didn't find any of them really that interesting that we were going to stretch for. So, we're looking for more on-campus properties, high hospital tenancy, if they happen to have some off-campus in it and, hopefully, in our core markets. So, at this point in time, there's really none of those out there, but we know when they come around, we'll certainly take a look them.
Yeah. I would – This is Tom Herzog. I would add that as we look to 2019 and where we'd like to grow, it really remains in the current three core segments that we have. But if we're looking at a large portfolio with a very low yield attached to it, that probably isn't going to screen for us something that we would likely acquire.
So, specifically to your question, a couple of the portfolios that have come up we've looked at and we've passed.
Okay. The HCA partnership that you outlined, that's interesting, but I also know HCA has been making a bunch of off-campus investments, and really the credit of these off-campus buildings have been improving as they take – as hospitals take more space in them. Wondering sort of why the focus only on on-campus and why not partner with HCA as they move more off-campus as well.
I don't think we're saying that we're not at all interested in off-campus. When we do look at off-campus, though, we would look at the kind of buildings you just mentioned, sponsorship by a strong hospital, certainly HCA, we would work with on those. In fact, in this development program, we announced there is one large off-campus development that's going to have a significant amount of hospital outpatient departments in it, and that's certainly one we want to do. So, we do look at off-campus, but it has to have the kind of metrics that interest us in the asset class.
Okay. And if I could just clarify one comment, I think, Scott, you made, just on the ramp back up, the potential ramp-up, You've said a couple of times it's going to take time. So, just to be clear, we should not expect in 2019 this 400 basis points you lost this year and overall maybe it's much, much higher over the last couple of years in these transition assets. We shouldn't expect any material ramp back up next year, but really view it like a two- to three-year timeframe?
Well, yeah, thanks for asking the question. So, we try to clarify that comment. There are two different ways to look at it. One is just the absolute dollars or occupancy, and I do think that we'll start to see a bounce-back sooner than later. We don't have to wait two to three years for that. We're already seeing the occupancy start to improve in the transitions that happened a couple of quarters ago. But the second way to look at it which is how we report is on a year-over-year growth rate basis. And that number will likely take a full-year to show a positive sign, because we have to do a full lap around the trough in occupancy, just given how much it's fallen.
Got it. Okay. That helps. Thank you.
Yeah. Just to add, Vikram, to your question, the recovery that Scott spoken to, just to be clear, is to bring those assets back to where they were performing prior to the transition. And that's the $25 million. As we think about new and engaged operators, we do think that there obviously is potential that they could perform better than that too over time. So, I didn't want to limit it just to the recovery from where they were performing prior to the transition period.
Got it. Okay. That helps. Thank you.
And our next question will come from Jordan Sadler with KeyBanc. Please go ahead.
Thank you. Couple questions on Shoreline, Pete, Tom. So, first, I'm curious, how do you shelter that gain, that $700 million.
Yeah. It's a good question, Jordan. So, if you remember, when we completed the spin-off in 2016, it was a NOL or a tax loss carry-forward that was crystalized, that was about $1.6 billion. We have utilized over the last few years probably about half of that, maybe a little bit more. But with this sale, we will utilize the remaining NOLs. And we also have, with utilizing these NOLs, some natural gain capacity that occurs every year, which you can't use if you have these NOLs, so we're able to tap into that as well. So, we can fully shelter the gain from the sale.
Okay. Well done. So, is there additional – are there additional opportunities like this to exit non-core assets or locations? I know you guys have some life science at Hayward, Redwood City, Salt Lake City, Durham, Poway.
Yes. No, I get it. This is Herzog again. Yeah, Jordan, obviously, we've got a number of trophies in the portfolio. In fact, in our investor presentation we have a page that presents a number of them. Most of those are going to be core to the portfolio we want to hold going forward or maybe literally the majority of the balance of them will be core to what we want to hold going forward. So, we certainly could choose to harvest something, but I think we'll find it less likely.
In the case of Shoreline, it was a different fact pattern. It was not core to our life science business and, therefore, it was a really good match and – but the rest of these assets, I think, are assets we're going to want to hold long-term.
Yeah. One other thing I would add, Jordan, too is, we talked about Shoreline, clearly, we had the ability to shelter the gain, but importantly, we've talked about this for a while. We really wanted to get back to BBB+ credit ratings metrics, and we were very pleased that S&P upgraded us today, this morning, in fact. And we actually put out a separate press release before the open, confirming that. So, that was also another part of our thinking. With this transaction, it was not only could we shelter the gains and it was a great price, but we also felt confident that we'd be able to get a credit upgrade, which was important.
And I'll just add one more thing to it, is once we utilize the remainder of the NOL, now we're in a position to need to manage with an annual gain capacity going forward like the rest of – most of the REIT world. So, as far as harvesting significant trophy proceeds which, again, I don't think we will, that would come with tax implications and we'd have to consider Section 1031s and the like so, just another factor.
Okay. And then, I'm curious where – maybe for Scott, where's the best place to put the money right now? I know you've been more cautious on the general recovery in SHOP at this stage of the cycle. But it seems like you're seeing some improvement not only in the – in your core portfolio, and the prospects, I realize, don't really brighten so much for the transition portfolio to later in the year, but it looks like it gets better. Is now a good time to put money to work in SHOP?
Yeah. Here's how we're thinking about capital allocation. We've got a big and very profitable development pipeline already in life science. There may be ways to add to that. We talked about accelerating Phase II and III of Sierra Point, now that we're fully pre-leased almost two years before the buildings even open on Phase I. We just announced an exciting development program in medical office. As Tom mentioned, it could be $100 million a year at a 7% to 7.5% return, that's a pretty accretive way to grow in today's market.
And in acquisitions for life science and medical office, there may well be more value-add unique opportunities that we would look at. I don't think you'll see us do big portfolio trades at very low cap rates, at least not today, that could change. But from where we sit today, we're very focused on more unique opportunities that would allow us to put our platform to use and create some yield.
And then, in senior housing, the landscape is changing quite dramatically and will continue to because of the operating environment and other factors. And at some point, there will be a tremendous opportunity to grow that business. We've been quite focused on capturing value, positioning ourselves to capture value from the assets we already own. But we are starting to think about perhaps external growth at the right time. I don't think that's tomorrow, but I do think you'll see us be very active in that space as well over time.
Thank you.
Our next question will come from Jonathan Hughes of Raymond James. Please go ahead.
Hey, thanks for the time. Question for Scott. I was wondering if you could maybe quantify what percentage of the 23% or so of the company that's currently senior housing triple-net now, how much of that would you like to flip to SHOP or be open to flipping to SHOP over the next few years to maybe capture more upside once senior housing supply-demand imbalance works itself out?
Yeah, it's a good question. Of the senior housing portfolio, about two-thirds of it today is triple-net and that's been a good day for HCP the past three years because it has insulated us quite a bit. Everybody's paid the rent, so we've been able to show attractive year-over-year growth in that portfolio despite underlining EBITDA declining. So, it's been nice to have that two-thirds mix in triple-net.
I would also point out that the asset quality in that portfolio is actually quite good, and that's been validated by a number of objective third-party research analysts and we agree with them. The markets are strong, stronger than SHOP, frankly. A number of the operating partners are very high quality. And those are the two things that you'd look for primarily to try to establish a SHOP relationship. So, we're totally open-minded about doing that.
And you're right that looking forward to the next couple of years, it may be an interesting time to convert some of these, having recognized a steady stream of rental income and then convert to SHOP when the business starts to take off again, which obviously it will. It's just a matter of time on that topic. Deliveries in 2019 are still going to be quite elevated for our portfolio and really for the sector at large, but it has now been three straight quarters of these starts declining and in some cases pretty materially.
So, as you start to look out beyond this current wave of deliveries, the demand and supply dynamics start to look a lot more attractive, especially given that the demographic, growth rate is going to accelerate quite a bit over the next 5 to 10 years. And it's really in 2018 that it's a trough. So, we'll start to see some pretty steady growth from this point forward.
And then, sticking with that, I mean, I think 15% or so of that senior housing triple-net portfolio matures in 2020. I mean, would you look to maybe flip that next year ahead of the assumed acceleration in demand? I mean, it makes sense to maybe do it at the trough as opposed to after things are already on the upswing.
We'll see. I'd say, we have the ability to be flexible and opportunistic. The three leases that mature in 2020, there are some very good quality operators there and some very high-quality real estate. So, it may, in fact, be an opportunity to convert (00:57:34). So, we have active dialogue with every one of our triple-net operators. There's nothing imminent, but it may well make sense. And if so, we'll do it.
Okay. And what's coverage on those three leases or three operators?
One is comfortably above 1.0. One is right around 1.0, and one is very slightly below 1.0.
Okay. All right. Just one more for me, and switching to life science, almost 10% of those leases mature next year, and I saw that renewals this quarter were down at about 11% cash spreads versus expiring. Is that 11% spread something we can expect next year? Are you seeing a sense of urgency from tenants looking to renew early to avoid losing out on their space and be future market-level of rent growth, just any color there would be great.
Yeah. Hey, Jonathan. It's Pete. I would say a little bit of what you just said, which is, certainly, there's urgency from a tenant's perspective to renew leases because there's just not a lot of vacancy. If we think about next year, we'd look at it right now, and we're probably about 50%, sort of in discussions and/or we have LOI signed at this point in time.
From a mark-to-market perspective, we actually think we can do a little bit better the next couple years than 11%. We think that it could be 15% to 20% of a positive mark-to-market on the leases that are expiring. So, while we do have, I think, it's about 9% of revenues expiring next year, we see some real opportunity within that. And, again, a lot of these are either spoken for, in discussions, or under LOI.
Okay. That's great. And there are no one-time items like the Rigel lease or the purchase option in there, so maybe we could see that segment return to the mid-single digits on an NOI growth basis, kind of like what it did this quarter ex the Rigel lease?
Yeah. And one of the reasons why we do like to talk about things ex Rigel is that, that probably is more appropriate for what we see the next couple years. I'm not going to give an exact number, but it's in the range of what you just described.
Okay. That's great. Thanks for taking my questions. Appreciate it.
Thank you. Hey, just a note. We've hit the one-hour mark and we still have a number of people in the queue. If you could, we'd probably better stay with one question and one related, so we don't have a two-hour call. So, let's continue, but if we could, on that basis, please.
Our next question will come from Drew Babin of Baird. Please go ahead.
Hey, good morning.
Hey, Drew.
I'll keep this quick. Focusing on medical office, most of what you own, obviously, is gross lease, decent amount of expenses and sometimes CapEx obviously fluctuates. But with shorter lease duration, TIs, leasing commissions can sometimes work against the FFO. I was just curious going forward with exploring opportunities with HCA, as well as within the Morgan Stanley JV, are you considering maybe more of an emphasis on longer duration triple-net type MOB leases or should we expect more of the same going forward?
Yeah, actually when you look at our lease profile, we have – the vast majority of our leases are base year, or fixed years, fixed top leases, so we do benefit from expense increases on those. I mean, the only time you really get hurt on a lease like that is, if you're in a period of expense reductions, and most of our expense reductions in the portfolio were kind of done in the 2008 to 2011 timeframe. We've been pretty successful at holding expenses kind of in the 1.5% to 2.5% range increases over the past five or six years.
So, we kind of like the base year format, unless it's specific to the market, we don't intend to switch to a lot of triple-net. When you look at pure gross leases where we get no expense recoveries, we only have about 15% to 20% of those in the portfolio, closer to 15%, and almost all of those are at our Medical City Dallas campus, we do a standard lease across the portfolio there. So...
Okay. So, just a quick follow-up, it sounds like growth activity going forward with HCA and Morgan Stanley likely look like more of the same.
Yeah. I would say, with HCA, that does create a program, so certainly more of the same there. Morgan Stanley is an excellent partner for us, so we'll see what plays out there as well. As far as other structures that could be similar that create value, we would certainly entertain those. Scott and team are working on those all the time.
All right. Great. That's all for me. Thank you.
Thanks.
Our next question will come from Michael Carroll of RBC Capital Markets. Please go ahead.
Yeah. Thanks. Scott or Tom, I kind of want to talk a little bit about your life science platform. I know you have a pretty good base in Southern San Francisco and you're expanding with Main Street (01:03:13) Cambridge. I mean, do you have any desire to get into any other of these top cluster markets, similar to, like, Seattle, for example, I mean, how do you guys think about that?
Pete, why don't you take them?
Sure. Hey, Mike. Our life sciences platform right now is San Francisco, San Diego and Boston, and we believe we have the dominant foothold in San Francisco, especially South San Francisco. We have a nice market share in San Diego, and we just re-entered Boston. To answer your question about going into new markets, I think we have plenty to do right now within our core markets. We certainly see a lot of opportunities in Seattle, Philadelphia. New York has come up more now. For us to enter into those markets, we'd have to be getting an appropriate yield to compensate for what we think is a riskier play versus the core markets. But for us, right now, there's plenty in our pipeline to do in our core markets and, frankly, if there was a market within the three that we'd like to try and expand, it certainly would be Boston, where we have a toehold right now and we'd like to get bigger, we've said that. We like the campus we have there with Hayden. It will be 600,000 square feet when it's done. So, it's kind of its own mini little cluster. But we'd certainly like to expand to do more in that market if opportunities present themselves.
Yeah. Thanks. And just, Pete, one last question related to that. How do you think about growing that platform, I guess, within those existing markets? Are you looking to find new land sites to develop on? Are you really focused on the sites you currently have and trying to maximize those first before you try to find new sites?
Yeah. It's probably more value-add. I talk about Hayden as a good example where, within that campus, we bought a core asset. We bought a value-add asset where there was some lease-up risk. The blended yield across the two of those was around 5.9% or a 6%. That makes sense to us. And then, we also got land that we had an option to purchase, which we've since purchased and, we think, yields there in the low-7 on that development. So, we'll look at opportunities like that because of our current cost of capital as opposed to just buying core low cap rate assets which, frankly, doesn't look as exciting to us as some of the other opportunities.
And Michael, Herzog here again. I'd just remind you, in addition to our already sizable pipeline, we do have a shadow pipeline that constitutes a future $800 million as well. So, it's not that when we complete the current pipeline, active pipeline that we're out of opportunities. I just wanted to make that clear.
Great. Understood. Thanks.
Thank you.
Our next question will come from Daniel Bernstein of Capital One. Please go ahead.
Hi. I actually might have two unrelated questions, but I promise to keep it to two.
No problem.
One, I think, everybody's focused on occupancy in the senior housing space. But you look at the Department of Labor, for instance, warning on wages, it's accelerating. So, my question really revolves around labor and, in particular, the transition assets. Have you seen any changes in employee turnover or contract labor or something that might signal that the margins on that portfolio could improve from here or the next 12 months?
Yeah. Hey, Daniel. it's one reason that the year-over-year growth rate and NOI has been so negative. We talked about occupancy being down, but we also have elevated expenses that should be temporary and that was driven in part by labor-related expenses like over time in contract labor, in filling vacant positions. So, that is one of the reasons that we see a lot of upside in these particular properties.
There was also a significant amount of turnover of leadership teams at each of the communities. So, that was also driving the NOI growth that we've reported this year.
But that stabilized now?
Well, some of the assets were only transitioned recently. So...
Okay.
...that's why I say that the occupancy improvement that we've seen is primarily from the assets that trend from six and seven months ago because it does take some time to put the new team, culture and systems in place.
Okay, okay. Some of the other REITs, not necessarily healthcare REITs, have talked about delays in deliveries of construction particularly with labor shortages, another labor topic, in the construction area, and have you seen any of that, as a change, how you pencil development going forward?
This is Tom Klaritch. So, we haven't seen any delays in construction. If you look at the projects we have in place right now, The Cove, it's on time, on budget. The Shore at Sierra Point, same thing, where we're moving ahead with that, actually a little ahead of budget. So, we haven't seen really any delays.
Okay. Yeah. I'll take that. Thank you.
Thank you.
Our next question will come from Lukas Hartwich of Green Street Advisors. Please go ahead.
Thanks. Hey, guys. Can you just provide some more color on the Shoreline cap raise? Are those rents below market or is there a redevelopment opportunity in that asset?
Yeah. Good question, Lukas. So, the leases are below market. They're probably about 25% to 30%. What I would say, though, is the weighted average lease term is four years. So, there's nothing you can do about that for another four years.
If we think about a market cap rate probably in the low 4s, if you factor in a mark-to-market on the rent, but then you've also got to factor in a pretty big increase in property taxes that any purchaser has to underwrite because the tax basis is so low in that asset right now.
So, 3.5% today, probably low 4s on a market basis. But you have four more years of lease term, which is important to factor into that.
Great. Thank you.
Thanks.
Our next question will come from Michael Mueller of JPMorgan. Please go ahead.
Hi. This is Sarah (01:10:20) on for Mike Mueller. You mentioned that you can participate with your Medical City investments. Could you elaborate on that and how unique it is in your portfolio?
I'm sorry. I couldn't capture that. Could you please restate it or just say it louder?
Sure, sure. You guys mentioned earlier in the call that you can further participate with your Medical City investment. So, could you guys talk a little bit more about that and how unique it is in your portfolio?
Yes. For Medical City Dallas. Yeah, Tom?
Hi. This is Tom Klaritch. Yeah, the Medical City lease is – its structure is a fairly low base rent to it, but we do share in the revenue of the hospital, so that's where the growth comes from, when the hospital does real well, like Medical City always has, we get a piece of that upside.
Right.
Our next question will come from Todd Stender of Wells Fargo. Please go ahead.
Hi. Thanks for staying on. Just with the volume of taxable gains you generated this year, I know you've got those offsetting losses you mentioned, is there a chance of a special dividend? I ask that because your rent will naturally decline into next year from these asset sales, which just brings into question your dividend level, FAD coverage, that kind of stuff, so any comments you have on maybe a special dividend and then the regular run rate?
Hey, Todd. I'll take this one. It's Herzog. No, there's no intention of doing a special dividend. Our dividend coverage, as Pete, I think, mentioned in the remarks, will land in the mid-90s. We're comfortable with that based on our balance sheet, our portfolio, and we'll certainly grow into a stronger coverage position, and there will be no reason for us to do a special.
Got it. Thank you.
Yeah. Thanks.
This will conclude our question-and-answer session. At this time, I'd like to turn the conference back over to Tom Herzog for any closing remarks.
Well, thank you, operator, and thanks for everyone for joining us today. And we'll talk to you soon. I guess, we'll be seeing a bunch of you guys in San Francisco next week. So, look forward to that. Thanks so much.
The conference is now concluded. We thank you for attending today's presentation. You may now disconnect your lines.