Healthcare Realty: No Reason For Dividend Investors To Become Bullish (NYSE:HR)

My previous article on Healthcare Realty Trust (NYSE:HR) was issued right after the REIT published its Q1, 2024 earnings deck. The recommendation was to avoid investing in HR, even though in the near-term one could expect some value crystallization from notable JV and full asset disposals at enticing cap rates. The reason to stay away from HR was related to HR’s unsustainable dividend, which at that time was not fully covered by the underlying FAD generation for several quarters in a row. My concern here was that we will not see HR landing in a territory in which it is able to accommodate the dividend from its internal cash flows due to all of the proceeds from divestitures going directly into the share repurchases rather than incremental CapEx projects or debt reduction.

Since the issuance of my previous article, HR has continued to go up registering a total performance of 9.8%, which is solid but ~ 50 basis points lower than total returns for the overall REIT market.

During this period, HR got cut by Wells Fargo from equal weight to underweight due to concerns about the asset disposal and subsequent share buyback strategy not bearing its fruit as HR’s multiple is too high to justify such action.

Let’s now take a look at Q2, 2024 earnings report to see whether something has changed that could alter my investment stance on this REIT.

Thesis review

The second quarter of 2024 resulted in a positive same store NOI growth of 3.5% – excluding the effects from a revenue reserve that was related to Stewart’s properties (tenant going through bankruptcy process). The multi-tenant NOI growth increased to 3.9%, which is in line with the upper end of HR’s guidance for this year. All of this was driven by solid expense control and new project absorption, which helped drive the top-line component higher.

However, the normalized FFO – which is the key metric measuring REIT performance – decreased from $0.39 per share in the previous quarter to $0.38 per share now. The key driver was also the revenue reserve against Stewart, where if this item had been excluded, the result would have landed at the exact same level as in Q1, 2024.

Here are two important items I would like to underscore.

First, after Q2, 2024 the total capital that HR has managed to access on a YTD basis from divestitures of partial JV stakes and full asset sales has reached $400 million. Of these proceeds, $295 million has already been allocated into share buybacks at an average repurchase price of $15.89%, which is circa 12% below the current price. The remaining capital was deployed in bringing down the outstanding debt. Yet, despite this activity – i.e., reduced share count and lower debt – HR has failed to improve its FFO per share result. Instead, the portfolio has become smaller, which per definition implies reduced diversification and the ability to scale. In terms of future capital allocation, HR’s plan remains intact, which is to generate more than $1 billion of liquidity from JV and asset sales.

Second, the case with Stewart sends a clear message that with the current NOI growth dynamics HR has not embedded margin of safety to absorb incremental headwinds from struggling tenants or other major items affecting the bottom-line (e.g., an uptick in vacancy rate).

Now, if we look at the distribution coverage from the underlying FAD generation (which in contrast to FFO accounts for additional building CapEx and new leasing costs), the picture has not changed. In Q2, 2024, HR recorded FAD of $107 million, while the quarterly dividend came in at $118 million.

Having said that, there were some positives in the recent earnings deck as well. For example, Q2, 2024 marked a second consecutive quarter, where the tenant retention rates are at 85% level, which is a notable improvement from the mid 70% in the previous quarters. The benefit of higher retention is that it allows HR to avoid lost rent from downtime, as well as keep the tenant improvement CapEx more balanced.

Plus, after the asset disposals and slight debt repayments, HR’s run rate leverage has reached 6.4x, which is set to continue go lower as HR directs additional funds from JV and asset sales towards optimizing it balance sheet. The current expectation is that the Management will utilize fresh liquidity from asset monetization process in order to pay off the $250 million term loan, which comes due next Summer.

Finally, the commentary in the Q2, 2024 earnings call by Rob Hull – Executive Vice President, Investments – provided a nice color on the relevant tailwinds that should help drive HR’s performance:

Health system top line revenue and our operating margins continue to improve. Providers were seeing solid outpatient volume and revenue trends. Longer-term, we expect demand to continue rising. Spending on health care services is expected to increase at 5.6% annually over the next decade. Over the same time period, the over 65 age group will grow at more than 9x the rate for the remaining U.S. population. And those over 65 are the largest users of health care services, spending 4x more than those under 45. The combination of limited new supply and rising demand creates a tailwind to support ongoing leasing momentum.

The bottom line

While on the same store NOI growth front HR has registered a decent performance, the fact that FFO per share dropped and even if adjusted for the revenue reserve remained flat sends a concerning signal. Namely, this indicates that the share buybacks done so far do not really move the needle that much – i.e., they are not sufficient to offset the lost revenue streams and then provide a meaningful incremental boost on the FFO generation. Also, the FAD continues to be below the quarterly dividend, which implies that HR has to use part of the liquidity coming from asset monetization to fund the current distributions.

In the long-run, HR is clearly exposed to secular tailwinds, which in combination with a gradual deleveraging and decreasing interest rates should help the Company to achieve positive dividend coverage.

However, it will take time until HR gets there, where during the process, new risks could materialize such as the uptick in revenue reserves for Stewart, which could take the Company back to square one.

For me, HR is still a too uncertain investment, especially from the dividend coverage perspective.