Healthpeak Properties, Inc. (DOC) Earnings Call Transcript & Summary

Welcome to the 5 p.m. session at Citi's 2022 Global Property CEO Conference. I'm Nick Joseph with Citi Research. We're pleased to have with us Healthpeak and CEO, Tom Herzog. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AP desk. For those joining us here today in person, to ask management any questions, please step up to one of the mics we have located in the center aisle of the room. If you're joining us remotely, type it into the question box on the screen, and they will come directly to me, and I'll do my best to ask them during the session. Tom, I'll hand it over to you to introduce the company and the management team, and then we'll get into Q&A.

Sounds good. Thanks, Nick. So my name is Tom Herzog. I'm the CEO. Joining me on the stage today are Scott Brinker, our President and CIO; Pete Scott, our CFO, and Tom Klaritch, our Chief Operating Officer, and he leads our medical office business.

Great. I'll start with the opening question. What are the top 3 reasons that investors should buy your stock instead of any other listed property company?

I would say there are 3. Obviously, there are a whole bunch of reasons, Nick, but we'll go with 3. I would say that the first reason is our irreplaceable trophy campuses that we have inside of our portfolio. After having gone through restructuring over the past half a dozen years, we have sold $18 billion of a $30 billion portfolio and then reinvested those proceeds in life science and MOBs primarily. I would have, those that have it in front of them, to refer to our latest investor deck. And on Slides 6 and 7, you'll see 9 portfolios -- or 9 campuses of life science and 9 campuses of MOBs. In those 18 mega assets, you're going to find that they sum up to somewhere in the vicinity of $530 million of NOI, and that represents almost half of the entire NOI of our entire company across our entire business. It would be absolutely impossible to replicate this portfolio in today's environment. They were put together over a period of 25 years for life science and 35 years in our medical office business. So that's the first reason. The second one is each of these 3 businesses is very unique in the business portfolio segments that we have been able to put together, and they each have their own individual market dynamics and are of very high barrier to entry. In life sciences, which represents 50% of our business, we're exclusively located in the 3 hot bed markets of San Francisco, San Diego and Boston with a focus on biotech tenants. I think importantly, we've been asked a lot over the last couple of days what's our mark-to-market inside of our Life Science business. Across the entire business at this point, it is a 25% mark-to-market. But to give you some context, that corresponds to $135 million of mark-to-market, it would be something in excess of 2% same-store growth incremental for the next decade or so. Second, in MOBs, that represents a little less than 40% of our business. We're 81% on-campus and 87% adjacent, which is the highest of any MOB REIT in the industry. And in CCRCs, which represents only 10% of our business, it's a very unique product. We think it's a lower-risk way to play senior housing. It's a continuum of care product, where you pay an upfront entrance fee oftentimes funded by the sale of the single-family home. It has an 8- to 10-year average length of stay versus typically 1 to 3 years in rental senior housing. And these are huge properties with an average of 500 to 600 units per property, and they sit on 50 acres of land. The third reason is we have a very strong development machine. And again, we have 25 to 35 years of experience in development in life science and MOBs. That's how we built those businesses through the decades, and a very strong track record of creating value. We have a current $1.6 billion development pipeline that is 75% preleased. We have an average 7% yield on cost across that portfolio or that pipeline that will produce about $120 million of NOI earn-in. And of that, based on our cost of capital, it is about $45 million to $50 million accretive. It will take a couple more years to deliver that pipeline. And finally, on the third reason, we do have an $11-plus billion shadow pipeline of future development projects through land bank and through densification opportunities, which will be a key driver of our growth for years to come. So in summary, I would say that we believe that Healthpeak is impossible to synthetically replicate through pure plays, given the unique nature of each of our 3 portfolios; second, our development opportunities, along with the densification and scale benefits; and then combining these businesses produces that great scale, which took us decades to complete. So with that, Nick, I'll turn it back to you.

Thanks. Maybe on that last comment, kind of your belief that you can't synthetically recreate it. Is that an asset-type comment from a CCRC perspective? Is that a development opportunity perspective? Or is it something unique to -- you mentioned being more on-campus on the MOB. Clearly, kind of the life science. But how do you kind of break down that comment of what really differentiates PEAK?

Yes, I'm really glad you asked that. So let's take life science. When we look at our portfolio of the 9 largest campuses we have, and we are in Boston or in South San Francisco and San Diego, and those campuses were built and developed one by one across a period of 25 years. There wouldn't even be the land in those locations to develop those properties today. And so obviously, it was a painstaking effort that took many, many years to put together, but in today's environment, it cannot be replicated. I know there's a lot of new players coming into life science. And I know that there are other markets, secondary markets that they can participate in, but not right in the heart of the best markets of San Francisco, the best markets of Boston and San Diego. In MOBs, Tom Klaritch, who's sitting to my left at the table, has been with the predecessor company to Healthpeak, MedCap, and that dates all the way back to 35 years ago. And literally, every asset in the portfolio that was developed or acquired was acquired by Tom. And he had a philosophy from way back before I knew Tom to develop in #1 or #2 -- with #1 or #2 hospitals in sizable markets and have those beyond campus. So those were 2 primary drivers of that. But when you have #1 or #2 hospitals and you have relationships, that allows numerous medical office properties, oftentimes connected to the hospitals, to be developed within those campuses, and Tom has been able to assemble a whole bunch of those. And then finally, in CCRCs, when I said that these were big projects, big properties, there are only 15 of them in our portfolio, but they're an average of 500 to 600 units per property sitting on 50 acres of infill land in major markets. They take 7 to 8 years to develop and stabilize. I've heard it said, even 10 years. And replacement cost is in the 2x to 3x what our basis in these assets are. So we have had 0 new supply in the last decade within a 10-mile radius of any of these campuses. So for those that want to play in CCRCs, I think we are the only public player that you could do so in any kind of a size. That business has dominated 85% by not-for-profits that are usually mission-based.

Why don't we start on life science? You mentioned the 3 cluster markets and kind of the scale you've achieved there. As you think about -- or as we think about larger kind of demographic trends, particularly on the kind of remote work front, right? You've seen companies move around to different regions, certainly, more flexibility from an employee standpoint. How large of a moat is there for those life science companies in those markets versus the incremental either office space or employee movement away from those markets?

Scott, do you want to take the conversion concept and the work-from-home dynamics that are driving this?

Yes. I mean, one of the things that is unique about the life science portfolio is that 98% is in the top 3 markets. Certainly, there are other places where there's demand for life science, Raleigh-Durham, Seattle. And we do have a few assets in those markets, but the depth of demand is overwhelmingly in the top 3 markets. And despite the work-from-home evolution over the past 2 years, we're still seeing a net inflow of capital into the big 3 markets over time. We've been monitoring this for over a decade. The top 3 markets have captured 50% to 60% of total capital coming into the biotech sector, and that really hasn't changed over the last 2 years in terms of number of startups. Even if a company occasionally starts in a different market, more often than not, we see as they grow and raise money, they end up coming into the big 3 markets because that's where the talent is located. And the reality is this business is heavily tied to the key research institutions and the professors and the basic science that's actually happening in those universities. And it seems unlikely to us that a Harvard or an MIT or UCSF, they're not going anywhere. These professors that are not going anywhere, despite the work-from-home nature of how the business world has evolved. So certainly, there's opportunities in other markets. But when we think about how to allocate our capital, which is obviously scarce, we've got a $10 billion pipeline in front of us and what we feel are by far the best 3 markets, plus relationships and critical mass, which in this industry is really important because there's so much velocity for the tenants who need more space, less space, but there's a lot of activity that having a big portfolio is critically important, especially when you start competing against new entrants who may have a conversion project in a more isolated location. We feel like our long reputation and scale in the business really is a differentiator.

Given the kind of macroeconomic uncertainty, obviously, we've seen a lot of that with the market. How do you think about, both from a public company perspective and also a VC perspective, potential space needs from many of these companies as there is current disruption?

Do you want to take that?

Yes, I can take that. I mean, life science is still relatively a niche business. In the top 3 markets, there's only 85 million square feet of aggregate lab space. That number is about 60% higher than a decade ago. So clearly, the business has grown as the funding into the industry has increased. But during that same decade, rents have grown at between 7% to 9% compounded. It's pretty impressive, and vacancies have gone from about 10% to nearly 0 in the top 3 markets, which tells you demand was growing obviously even faster than that new supply. So we don't see that slowing down. 2020 was a record-breaking year across the board for capital raising, and 2021 was even stronger. Now this year, the IPO market has started off fairly slowly. That's not just biotech, that's across the board, all industries. But we've continued to see venture capital funding be really strong. The government is, if anything, increasing the amount of money they're putting into this industry, which is where the basic science starts. It's kind of the starting point of the next wave of new startups. So net-net, we actually still see the funding environment accelerating for this business even if the IPO market is a little slow right now.

You mentioned the 25% current mark-to-market on rents. I think in the past, you've talked about a 6-year WAULT. How do you think about the ability to eat into that mark-to-market over the next few years?

It's going to be lumpy, Nick. It's lease by lease. It's as leases turn. Sometimes, they'll be below market. Sometimes, they will be at market. There will be some timing on the term cost for the tenant TIs, LCs. So the exact breakdown of the next 3 years, we haven't provided that yet. But just think in terms of the $135 million translating into a 25% mark-to-market over a period of time. And that does represent, I think it's 17%, 18% of our total AFFO over time. So there's always some lumpiness in that, but that's the -- those are the general numbers.

And how are you thinking about supply in these markets, either from new builds or conversions?

Do you want to start with supply?

Yes. Again, I'll just stick with the 3 markets since that's most relevant for Healthpeak. But over the next 2 years, there's plus or minus 17 million square feet being delivered off of a base of $85 million. So it's significant supply growth. That breaks down to about 10 million square feet in Boston. Over the next 2 years, about 4 million square feet in San Diego, 3 million square feet in the Bay Area. So fairly significant, but the pre-leasing, at least for the 2022 deliveries, in most markets it's 60% or higher. For example, our pipeline is $1.5 billion today. And other than one project that essentially just started, we're pretty much fully pre-leased, And we're already getting good activity on that project that doesn't even deliver for another 18 months. So the other point I would -- I think is important to keep in mind when you think about new supply is that when I say 17 million square feet, every project is kind of 1 square foot equals 1 square foot. There's no differentiation. And about 40% of that new supply is actually conversions of office property. The other 60% is purpose-built. So when we think about competition, it's one thing if one of the tenured, long-standing life science companies built a mega campus next door. That's quite competitive. It's a different thing if there's a one-off conversion asset 10 miles away that's 100,000 square feet in a new entrant. So we really break down the 17 million square feet when we think about how competitive it is. And our assessment is that roughly half of that is truly competitive to our portfolio, and the other half is -- right now, everybody in lab is full. But when you fast forward maybe it's 5 years from now or 10 years from now when supply and demand are presumably more in balance, the higher-quality campuses, the better locations will be better positioned to compete. And that's where we focus our capital.

Nick, I'm going to add a couple of things to what Scott said. When we think in terms of what drives this life science demand, biotech demand, it is the new scientific technologies that are coming online. And we're all aware of this. It's gone from chemistry-based drugs to live organism, large molecule drugs that are now curing and treating diseases that just a decade ago we simply died from or spent a lifetime with illness. And this has accelerated over the past couple of decades. If we just went back, for instance, to the year 2000, the FDA review time has almost cut in half in the last decade, so the speed of drugs to delivery. If we look at the number of new FDA drug approvals, it has increased by probably 2.5x. And much of that is biotech-type drugs, so the large molecule, live organism-type drugs, like the mRNA technologies that came into play. And from a funding perspective, which drives a lot of this, if we went back to 2011, there was $45 billion of funding that came from NIH, from venture capital, from partnerships, IPOs, secondaries. That roughly $45 billion is now somewhere more in the vicinity of $150 billion to $160 billion. So the amount of funding that came in was dramatic as well. So that's what continues to drive this heavy demand, and so then it becomes an equation of what's the new supply look like relative to the demand and where does that new supply -- how is that new supply located and is it purpose-built, and which major markets is it in? Because which markets it's in will dictate how much scientific talent, how much VC funding, which universities are providing this initial research to create these new drug technologies that are funded primarily by NIH. So those are all the different things that we take into account when we're considering markets.

Scott, I think in your comment on kind of parsing through the supply, right, you talked about conversions and you also said 10 miles away. Put aside the distance, right, how do you think about purpose-built versus conversions?

Certainly, conversions can be successful, and we have a few in our portfolio. And today, virtually anything that's life science is full. But when you look at our aggregate portfolio, 99% virtually is part of a campus where you have an amenity -- modern amenities, gym, restaurant, outdoor activities, green space which we think really does differentiate those properties versus a stand-alone conversion asset at the end of the day. When we're competing for tenants, all things being equal, the well-located, highly-amenitized campus setting, where tenants know that they have room to grow when they need to, will certainly win more than their fair share of leasing battles. In particular, given that roughly 75% of our leasing in any given year comes from existing tenants. I think that's the other thing that maybe is not as well recognized in the public markets or even from new entrants that the existing players, incumbents with scale really do have a massive advantage. I mean, not only is it a unique property type to build and operate it, but so much of the leasing activity is being created by existing tenants that we feel the combination of the higher-quality campuses, plus the existing tenant bases will put us in a good position even if the market supply and demand are more in balance over time.

Maybe we'll to shift to medical office. You've talked about obviously being vast majority on-campus, most of any of your peers. How do you think trends post-COVID will impact on- versus off-campus performance?

I think the trends moving forward are going to be pretty similar to pre-COVID. I don't see much of a change there. We like the on-campus model. We've followed that model for as long as I've been in the industry. You tend to have more specialists when you're on campus. The specialists are more sticky. Retention tends to be better. NOI growth tends to be better. It's always worked well for us. The off-campus anchored are -- would be the next class that we'd look at. They tend to work very well to the hospitals. Normally put some departments in there, whether it's an owned physician group or radiology center or dialysis center. So they tend to work fairly well also. And I think that will continue as we move forward. I don't see much change in the industry regarding that.

One of the topics we keep hearing, obviously, is inflation and the impact on MOBs. Obviously, it's kind of steady growth, certainly get that benefit during downturns. How do you think about the ability for MOBs to keep up with -- in a higher inflationary environment?

Yes, probably in the short run, I would think we'd stay in that 2% to 3% mark-to-market growth rate that we've been in for a while. But if I look back kind of the 1999, 2000 period when inflation was up, we tended to have more leases that were CPI-based and with a collar of, say, 3% floor and 5% ceiling. And so you had a little better growth in rates back then. We'll continue to monitor that. Right now, we're sticking with fixed escalators, but we probably would, as we move forward, if inflation stays up there, maybe switch to that CPI-based with a collar.

And what was it that made that change, I guess, back in the '90s from CPI-based to where it is today?

I think because the inflation was down so long, we were sticking with that 3%. It was kind of the low end of the floor or it was that floor and doctors were accepting that, and they continue to accept it. So we pushed those 3% escalators fixed. If you look at our portfolio overall, we're about 2.7% fixed -- on average, fixed escalators. So the bulk of those are 3%. We got some in the 2.5% range.

And how are you thinking about the growth of that portfolio, obviously, of the development kind of relationship to grow up from there? But how do you think about acquisitions, too?

I'd probably take that one. From an acquisition perspective right now, we're probably not all that aggressive given our cost of capital. If we looked at on-campus, MOBs are probably in the mid-4s. If we looked at adjacent, maybe it's a 4.75%. Off-campus, it's hard to tell. It could be higher. So against our strategy and our cost of capital, that's probably not a good trade, unless we have excess funds that have come in for some reason. As far as growth, Tom and his ex-colleagues over at HCA have put together a very nice HCA development program that we're adding to, it seems, every quarter. We'll probably spend $100 million a year on that program to continue to grow HCA on-campus product. It's usually about 50% pre-leased, anywhere from probably 35% to 65%, and so we'll continue to get some growth there. I think Tom will find some other avenues through his relationships to have additional MOB development. And they come in at nice yields and, like I said, well anchored. So that's probably where we see our growth in MOBs.

And what sort of yields are those relative to the 4.5% you were talking on acquisitions?

It's probably -- and these are on ground leases just based on the fact that they are on campus, but they're probably in that 7% to 7.5% range.

So I think the third point, Tom, you made was kind of the development machine, right? So 7% yield on cost on the current pipeline, but $11 billion shadow pipeline. How should we think about kind of development spend going forward in deliveries as we look to monetize some of that pipeline?

Pete, do you want to take that?

Yes, sure. Nick, we're not going to do the full $11 billion in 1 year. We're going to phase it in over 10 to 15 years. I would say the levels we're comfortable at right now from a development perspective, and this is development and redevelopment, is around $750 million of spend annually. And the different pieces of that, to give more specifics, and these are just approximate numbers, it's probably around $150 million of redevelopment every year. And that's going to get split mostly between medical office as well as some life sciences as we bring some of these assets up to modern-based standards. Some of them have tenants that have been in them for 20-plus years. There's another $100 million probably every year of MOB development spend from this HCA program that Tom just talked about. And then the balance will be towards life sciences development, so about $500 million, again, approximate numbers, and this is what we see over the near-term horizon. And you didn't ask this, but maybe I'll talk about it a little bit more. So from a funding perspective, how do we get comfortable with those types of levels? I mean, one of the beauties of the way we think about our development program right now is it's largely self-funded, right? We have retained earnings. That was a very important part of adjusting our dividend a few years back. So we have about $150 million a year of retained earnings, which we will put back into development and redevelopment. We'll always look towards some noncore sales and some of the seller financing repayments that we'll have in the next few years, that's probably in the $300 million range every year. And then the balance of it will largely come from additional debt capacity that's generated from our EBITDA growing, and that's really from 2 sources. One, new developments coming online, and the other source is the same-store growth we'll get from our existing portfolio. And we can moderate our sales to the extent that we feel like we want to do some additional sales or we could slow that down if we wanted to, to the extent that we're trading at a level that we feel comfortable raising equity in the markets. And we'll likely do that under the ATM. So...

Upfront, you talked about the portfolio transition and all the asset sales that you've made. Where are these $300 million of noncore sales coming from? I mean, you've talked about your life science portfolio. Kind of seem like you're pretty happy there. Certainly, the handful of CCRC assets. Is it MOBs? Or are there still kind of orphans within the portfolio? How are you thinking about what is noncore today?

Nick, I would state it as simply as it's just annual pruning. Every year, our portfolio gets a year older, obviously. And there's usually somewhere in the vicinity of $300 million per year where an asset has extended the useful life inside of our portfolio and it's time to move it on and let somebody that has grander plans for that asset to acquire that. It usually costs us a couple of hundred basis points in cap rate versus cost of funds, but that's a good trade for us to make annual in.

And as you think about the $150 million annual redevelopment spend, how much incremental yield can you get on that? Or is it really just kind of recapturing kind of the ability to re-lease?

Did you say the $750 million?

No, the $150 million on the redevelopment side, you said, of...

Oh, the redevelopment. Yes, we're looking at a cash on cash return on that somewhere in the vicinity of typically 9% to 12%. And this is primarily in MOBs. And with an MOB asset, a 9- to 12-year period -- excuse me, 9- to 12-year percent, but it usually extends to be almost a 20-year useful life for the improvements that we've completed. So that does produce a real IRR on the spend. And if you've been inside old medical office buildings with old elevator shafts and lobbies and doors that are rotting on the bottoms, you'll recognize that redev in MOBs is a very real thing. Oftentimes, the property is attached to the actual hospital buildings and then you capture rents and get the return from it. So it's a good trade for us.

Do those typically come with extended ground leases?

Tom, do you want to answer that?

Not typically, we do those internally. Most of our ground leases are -- or the bulk of them are with renewal options in the kind of the 75-, 78-year range, so really not looking to extend many of those. We're really looking to capture rate upside or occupancy upside with those improvements. And typically, we do. That's where 9% to 12% comes from. And we're really upgrading all of the systems in the building. So we look at the roof system, the window systems, common areas, all the HVAC, MEP equipment and upgrade them where necessary. And they're usually much more efficient when we're done also, so we do get some expense savings on top of that.

How are the conversations with Cambridge going on the Alewife development?

Good. Scott, do you want to give us some color?

Yes. There's a history to that site. And Cambridge is difficult to develop, which ultimately will be our best brand. I mean, it's one of the reasons we like it so much. We're having enormous success within walking distance. We already own 1.1 million square feet in that neighborhood. It's essentially fully leased. We deliver new development later this year that is going to beat our underwriting projections by more than 30% on the rent. So there's certainly demand for space. This 36 acres that we assembled, it's part of the Alewife neighborhood, so it's got great access to Route 2 in the Alewife train station. So we feel like from an accessibility standpoint, it's highly desirable for tenants, plus the Cambridge address. And to have 36 largely contiguous acres that -- in the interim, while we go through this entitlement process, we're being paid a roughly 4.2% GAAP yield. So we're not in a huge hurry. At the same time, we do expect to eventually develop or densify a fair amount of that campus. So in the interim 3 months since we announced the acquisitions, we've started to actually meet in person with the local stakeholders, including the city councilors, and those discussions have been very productive. There are certain things that naturally the city is going to want, virtually everything we expected and underwrote and we think we can deliver. So it is going to take some time to go through that entitlement process, but nothing to date has been a negative surprise. It's kind of been in line with our expectations, and we think we ultimately will deliver a vibrant mixed-use product that the city and the local stakeholders actually really do desire. And in some ways, this moratorium, if it does in fact pass, in some ways, it's more of a mechanism to enact the rezoning that both we want and the city and the local stakeholders want. So it's not necessarily something that we would have proposed ourselves. And at the same time, it's not something that we're fighting because what they're trying to do with this moratorium is exactly what we had in mind, which is to rezone this neighborhood.

What's your #1 ESG priority in 2022?

If we took the last decade, and we have been reporting for a decade, we just issued a tenure report this last year, we had 35% greenhouse gas emission improvement during that period of time. Energy savings and recycling, we're in the 16% to 17% range during that decade. Over the next 10 years, we're looking for 37% of GHG, 10% to 15% energy, water recycling and all of our new life science developments at LEED Gold.

Rapid fire. What will same-store NOI growth be? I guess we can do MOBs and life science for the sector overall next year in 2023.

Did you say same-store, Nick? I apologize.

Same-store NOI.

Yes. So let's give it 4% to 5% for life science, 2% to 3% for MOB and 5% to 10% for CCRCs rent growth.

Where will the 10-year U.S. treasury yield be a year from now?

I'm going to disappoint you and give you the same answer I give you every year. We don't believe we can predict interest rates. We go to the forward curve. It's a little over 2% in the forward curve.

And then finally, will the health care REIT sector have more or fewer public companies a year from now?

Fewer.

Great. Thank you very much.

Thank you, everybody.