Healthcare Realty Trust's (HR) CEO David Emery on Q2 2014 Results - Earnings Call Transcript

Aug. 3.14 | About: Healthcare Realty (HR)

Healthcare Realty Trust, Inc. (NYSE:HR)

Q2 2014 Results Earnings Conference Call

July 31, 2014 10:00 AM ET

Executives

David Emery - Chairman and CEO

Scott Holmes - EVP and Chief Financial Officer

Doug Whitman - EVP Corporate Finance

Todd Meredith - EVP Investments

Carla Baca - Director of Corporate Communications

Bethany Mancini - Corporate Communications

Analysts

Michael Carroll - RBC Capital Markets

Jeff Gaston - KeyBanc

Michael Knott - Green Street Advisors

Daniel Bernstein - Stifel

Lina Rudashevski - JPMorgan

Todd Stender - Wells Fargo

Operator

Good day and welcome to the Healthcare Realty Trust’s Second Quarter Analyst Conference Call. All participants will be in listen-only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. (Operator Instructions). Please note, this event is being recorded.

I would now like to turn the conference over to Mr. David Emery, Chairman and CEO. Please go ahead, sir.

David Emery

Thank you and good morning, everyone. Joining us on the call today Scott Holmes, Doug Whitman, Todd Meredith, Carla Baca and Bethany Mancini. Now Ms. Baca will read the disclaimer. Carla?

Carla Baca

Thank you. Except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risks and uncertainties. These risks are more specifically discussed in a Form 10-K filed with the SEC for the year ended December 31, 2013. These forward-looking statements represent the company's judgment as of the date of this call.

The company disclaims any obligation to update this forward-looking material. The matters discussed in this call may also contain certain non-GAAP financial measures, such as funds from operations, FFO or FFO per share, funds available for distribution, FAD or FAD per share. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release for the second quarter ended June 30, 2014. The company's earnings press release, supplemental information, Forms 10-Q and 10-K are available on the company's website.

David Emery

Thank you. We’re pleased again to report positive results for the second quarter, our revenue and FFO growth correlated with increasing vigor in the company’s portfolio, positive operating metrics sustained momentum in the development conversion properties and solid internal growth.

Leasing continues to be the strong pace during the quarter the company’s tenant retention cash re-leasing spreads and annual bump again showed progress. After beginning several years ago with the major sale of senior living assets we have continued to refine the portfolio, shedding smaller off campus buildings that were bundled in large portfolios acquired, adding hospital centric facilities and homing the growth potential of the properties.

The company has been actively developing innovative leasing and operational strategies that we expect overtime will enhance revenue per occupied square foot. With stable tenants, superior rent coverages, low fungiblity and an average multi tenanted lease size of only 4,400 square feet the benefits we gained from management tactics should result in meaningful and lasting growth. And further enable the company to pursue only strategic investments and minimize risk. To produce additional spread particularly in such a highly sort after asset class.

Our ability to invest selectively and grow internally from solid portfolio of outpacing properties, a land with well established heath systems ensures our low business risk profile. We believe the latter will become increasing critical as health insurers reform and the care act gradually reshape the economics of the healthcare industry. Despite the uncertainly that still remains we anticipate minimum impact on our properties. For Healthcare Realty, the future is closely tied to the success of the health systems we are partnered with. Financially stable systems with strong balance sheet and the means to deploy capital should be able to absorb near-term risk as they pursue new initiatives, expand market share, lower cost and integrate outpatient care.

We continue to selectively target properties on our near campuses of such health systems that attract the best physician practices and prosper in the long-term.

Given the size and annual growth of the outpatient property market, we anticipate development as well as acquisitions, will proceed at a measured and balanced pace.

Lastly, we believe our investment strategy remains on point, relevant to the current trends in the healthcare industry, stable within a growing sector and positioned to produce lasting returns.

Now I'd like to turn it over to Ms. Mancini who will summarize our views on current events and trends related to the healthcare industry. Bethany?

Bethany Mancini

Operational teams for healthcare providers in the second quarter centered on improving patient volume trends and positive health reform metrics. Exchange enrollment reached almost 8 million of which approximately 4.8 million enrollees have been previously uninsured.

Providers continue to face the challenges of Medicare and commercial insurers, attempting to limit their needs and patient utilization, while at the same time incurring large expenses to invest in the technology and staff required for participating in new payment model.

The prevailing thought has been that efforts to lower healthcare spending would be offset by higher revenues from an increasing volume of insured patients. Providers are optimistic on volume trends and earnings, with the sustained focus on cost control.

Even as the implementation and nuances of health insurance reform continue to unfold, it is becoming more clear that the leading health systems will be those that can attract greater patient volume, expand market reach through specialization, adopt payment models that follow reform incentives and improve efficiency. While the profitability of accountable care organization and quality based model remains in question and will play out over time, the cost efficiency and patient preference of outpatient care particularly in non-hospital setting is a proven and winning priority for health systems.

Also faced with rising demand on the horizon from an aging population, health systems must contain with physician shortages, making their recruitment and support staff essential. Healthcare employment data continues to reflect these trends and the integration of physician practices within health systems. Ambulatory care settings added almost 182,000 jobs. During the last 12 months ending on June including more than 55,000 jobs in physician offices. Adding an average of 5,000 jobs per month over the past year physician offices have been the largest contributor to ambulatory service job growth in 2014, while hospital hiring has remained largely flat.

We view Healthcare Realty’s medical office facility as well positioned to thrive on the growing demand to lower cost outpatient settings, providing on campus space for physicians which foster hospital utilization and direct payment and delivery model. Contrary to general perception average physician income continued to increase albeit slowly and Healthcare Realty's tenant rank coverages remain strong. The expanding role of physicians and their extenders to meet greater volume demand while keeping costs low will benefit Healthcare Realty in the entire growth of our on-campus medical office in our patient facility.

Medicare rates for physicians are expected to remain stable through the end of March 2015. And with Congress focused on reelection effort any significant healthcare legislation it’s unlikely this year. Legal issues remain however for the embattled Affordable Care Act, including the latest conflicting ruling in the DC and Virginia Circuit Court. Concerning weather individual premium subsidies are available in the 36 days that have federally run insurance exchanges. Its widely expected that the subsidies will remain as the state continues various needs to work around the restriction regardless of the outcome of the case in the quarter.

Moving on with our complete clarity seems to be the new normal for insurers and providers, it should allow them to continue to benefit from the increasing number of insured patients. Healthcare Realty will continue to pursue investments in their outpatient sector confident in slow business risk strategy and the internal growth opportunities inherent to be these properties supported by tenant favorable revenues for mostly private payer sources. David?

David Emery

Thank you Bethany. Now we will go to Mr. Meredith to give a specific information regarding recent investments and development activities. Todd?

Todd Meredith

During the second quarter the company acquired two properties for $15.2 million and on campus MOB Greensburg North Carolina affiliated with Cone Health and another on-campus MOB in Austin Texas affiliated with Seton Medical Center part of the Seton Health.

In July for $19.9, we also acquired in on-campus MOB in Minneapolis affiliated with Alina Health. While cap rates remain low especially for large high profile portfolio, we continue to find attractive individual properties in the mid 6% to 7% range. We are currently under contract or letter of intent to acquire several MOB at these same price levels and we remain comfortable reaching the mid-point of our guidance range of $75 million to $150 million for 2014.

The company sold two off-campus properties during the quarter for $6.2 million, we expect to sell some additional properties during the balance of the year that could quickly put us at the top end of our guidance range of $40 million to $60 million. Selling smaller off-campus properties that came to us in bundled portfolios at blended cap rates below 7% allows us to accretively recycle capital in the better property that add to the company's growth profile.

Occupancy at the 12 development conversion properties improved to 70% with over 54,000 square feet taking out occupancy during the quarter, generating 3.4 million of cash NOI in the second quarter. And on pace to reach quarterly cash NOI of $4 million to $4.5 million by year-end on occupancy of about 80%.

Adjusting for deferred rent partial occupancy during the second quarter run rate NOI would have been $4.1 million. As the current leasing level of 82% converts to occupancy, the run rate NOI should exceed $5 million per quarter. Leasing in the additional 185,000 square feet most of which is two properties at current market in rates will produce fully stabilized quarterly NOI of about $6.9 million or the midpoint of $25 million to $30 million per year.

Our recent discussions with health systems suggest the burgeoning interest in new facilities to expand hospital base outpatient service and held newly aligned physician groups. Although timing is always somewhat unpredictable we have several developments percolating and we expect a couple of starts by year end or early in 2015. At an average size of about 50,000 to 100,000 square feet and investment of $15 million to $25 million, initial leasing commitments should range from about one third to well over half of the developed space. With stabilized yields of 100 to 200 basis points above acquisition pricing.

Interest in new facilities is a leading indicator that providers are planning for a steady rise in outpatient volume, health systems and physicians are aggressively reorganizing their delivery systems to capture expected volumes and the economic incentives of outcome based care which strongly favors outpatient services.

It is critical to align with leading systems that have the resources and knowhow to remain competitive, adopting the health insurance reform and embracing strategic change with their physician base, ensuring favorable demand for well located hospital aligned outpatient facilities. If you’ve heard us lately you know we have been highlighting the dynamics of internal growth on a more granular level. However the last year we have been implementing the systems to gauge pricing power and push rental rate growth. How we have refined incentive plans to align with key growth measures in an effort to drive incremental but meaningful cumulative improvements in our internal growth profile.

With 15% to 20% of our leases expiring each year we have more opportunity to reset rents than most. Measurable progress will not be quick or perfectly smooth, but cumulatively these efforts make a difference. In the mean time, we are applying the same keen awareness of pricing power to our investment criterias.

Balancing valuating parameters with the potential for rental rate growth. Whether an acquisition or development, we want to own properties that are aligned with leading health systems in markets with strong demographic. We want to own properties that are well positioned relative to competitive alternatives attracting tops physicians. And we want to own properties where we can use our expertise to deliver a strong value equation to our tenants, while accelerating rent growth and creating operating leverage.

This perspective guides our entire operating and investing strategy including acquisitions, developments and dispositions. Prioritizing quality over quantity, intrinsic rather than leasehold value, internal more than external growth, pure play versus asset type diversification offering investors a distinct choice among healthcare REIT. David?

David Emery

Thank you. Now on to Mr. Whitman to update everyone regarding our balance sheet and capital market activities. Doug?

Doug Whitman

During the quarter, Healthcare Realty issued equity through its aftermarket or ATM program having completed just over $35 million of acquisitions year-to-date and with additional acquisitions expected to close later in the year.

With our equity trading at an attractive employed cap rate relative to these investment opportunities. We issued approximately 1.4 million shares in the second quarter in early July, generating net proceeds of $34.5 million.

As we look ahead at the additional acquisitions that are expected to close in the third and fourth quarters, we will be judicious in raising additional equity, balancing the need for additional capital raises with the ability to fund some of these investments with proceeds from upcoming dispositions. The combination of our portfolio’s internal growth and the increasing contribution of our development conversion properties have improved several key debt metrics, notably our fixed charge and debt to EBITDA ratio. Moody’s cited this progress along with the quality of the company’s portfolio its history of growing the portfolio prudently and the lack of near-term debt maturities has rationale for upgrading the company’s ratings outlook to positive.

Over the past several months we’ve met with investors to analysts to discuss our balance sheet, our propensity for internal growth and the opportunities for new investments. During these meetings we are frequently asked how the Affordable Care Act is impacting our business, as one might expect from such a complicated and far reaching law its effects are showing up in numerous ways. One impact that have observed is the tightening of the physician hospital relationship. Historically physicians were generally autonomous, and typically practiced two or more hospitals. Today, a rising number of physicians have same sort of formal or affiliated relationship with the single hospital. The hospital may directly employee the physicians, form an ACO with several doctors or simply offer administrative support in an increasingly bureaucratic environment.

Physicians will look at partner with the health systems that have the capital and vision to successfully start or expand the clinical programs that will help their practices to try. The strong one gets stronger which is why the single most important factor and whether we invest in a new property is the stability of the adjacent health system.

MOBs already have a reputation for having sticky tenants but we expect the health insurance reform will further increase the likelihood the physicians mostly integrated with the hospital will renew their leases. It has been our experience that a health system with a growing presence in a market and direct affiliations with the community’s leading physicians groups who generate strong demand for on-campus MOB space which keeps occupancy high and provides the opportunity to steadily push rents.

While real-estate fundamentals such as locations remain critically important, the changes in the healthcare landscape triggered by the ACA make differentiating the relative strength and quality of hospitals equally imperative. This mindset guides investment strategy and fits seamlessly with our conservative capital management and low risk profile in a dynamic industry which continues to demonstrate broad and every increasing demand. David?

David Emery

Thanks Doug. Now for Mr. Holmes to give us an overview of the results of operation and other financial matters. Scott?

Scott Holmes

The company reported second quarter normalized FFO per diluted share of $0.36, a normalized FAD per share of $0.37. NAREIT-defined FFO per share was $0.38 in the second quarter. The company normalized for a refund of operating expenses related to prior years of $1.9 million and expects the continuing benefit of this refund to be reduction of baseline operating expenses of approximately $700,000 annually.

The dividend payout percentage on normalized FAD for the second quarter is 81.1% in our normalized FFO is 83.3%. Normalized FFO dollars grew $5.5 million or 92.2% year-over-year to $34.2 million. Over the same time period, normalized FFO per share increased 12.5%. Normalized FFO dollars increased sequentially by $700,000 or 2.1% from the preceding quarter. Attributable primarily to an increase in revenue of $1.1 million, offset by an increase in property operating expenses of $700,000 and the decrease in general and administrative expense of $300,000, which was the result of non-recurring increases in the prior quarter.

The company again produced solid leasing results. The second quarter cash re-leasing spread of 2.5% in the multi-tenant portfolio is at the upper end of the range of 0.5% to 2.5% in recent quarters. Annual rent bumps were up slightly at 3%, tenant retention was up from 81.9% last quarter to 86.7% this quarter and the spread on re-leasing yields was again positive in the second quarter. With strong tenant retention and leasing activity, occupancy in the same store portfolio again remained steady at 90.5%.

Year-over-year multitenant same-store revenue was up 2% but expenses were up 2.4% which caused NOI to be up1.6%. Property taxes increased which were up 4.9% over last year and 11.3%, sequentially. Sequentially multitenant same-store revenue was up 0.9% while expenses were up 7%, resulting in NOI improving by 1%. Our single tenant properties saw year-over-year revenue increase 2.7% and NOI increase 3.4%. Sequentially, NOI from single tenant properties was about even with the drop in the same-store revenue of 0.1% and lower expenses of 3.7%.

On a combined basis, the total same-store NOI was up 2.1% year-over-year and 0.7% sequentially. Our property management and leasing team will continue to implement steps to mitigate the effect of rising property taxes and other non-controllable operating expenses. We continue to increase our net and modify gross leases which allow for some component of operating expense recovery.

Those leases now represent over 80% of the leases in our portfolio, an increase of nearly 10 percentage points since the first quarter of 2013. As we said last quarter, any quarter-to-quarter changes are not necessarily indicative of a trend and must be viewed in the context of several quarters. We continue to expect the long-term same store NOI growth profile to remain in the 2% to 4% range. David?

David Emery

Thank you, Scott. Operator, we are now ready for question and answer period.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions). And our first question comes from Michael Carroll of RBC Capital Markets. Please go ahead sir.

Michael Carroll - RBC Capital Markets

Yes, hi. I know you guys recently made some organization changes in an effort to get more aggressive on the leasing front. Is that what drove some of the improvements that we saw in your cash lease spreads and your same-store results this quarter?

Todd Meredith

Mike, this is Todd. I would say, it’s a little early to really see those results come out, maybe at the margin it helped a little on cash re-leasing spreads. But it’s still a little early. I think you will start to see that more in 2015, maybe a little bit through the rest of the year. But again, it only applies to leases that are expiring and we are renewing and some new leasing. So, it's going to be a very slow paced in process. So, I think it's a little early to tell, generally I would say we've seen some good signs with some better bumps, some better releasing spread. So, it will be a process.

Michael Carroll - RBC Capital Markets

Okay. And Todd, can you give us some color on the deals you mentioned are under contract right now? Did you say the size of what you're working on? And I know you indicated you think you could complete in the midpoint of your acquisition expectations.

Todd Meredith

Right. I mentioned these were properties, there are under letter of intent or under contract. And certainly that we think that gets to the midpoint and certainly had prospects beyond that. But we don't obviously want to point to that, until they are a little firm, more firm. So that's kind of where we are for the year, I think we're comfortable with the guidance range, whether we hit the top end or not, we'll update everybody next quarter.

Michael Carroll - RBC Capital Markets

Okay. And then can you kind of give me some color on why you reduced your acquisition expectations by 25 basis points this quarter? I mean, did cap rates just draw about, declined about 25 basis points for the past three to six months?

Todd Meredith

That's the general idea with that change and our guidance on that. We still continue to see attractive opportunities at 6.5%, 7%. But I think suggesting it goes to 7.5%, it's a little tougher in this environment, just with the trends of late, so it’s just a little bit of a movement kind of reflecting the six to nine months.

Michael Carroll - RBC Capital Markets

Okay, great. Thanks.

Operator

And our next question comes from Karin Ford of KeyBanc. Please go ahead.

Jeff Gaston - KeyBanc

So hi, this is Jeff Gaston here with Karen Ford. One actually very quick question, when do you expect multi-tenant NOI to hit the 2% to 4% range?

David Emery

The 2% to 4% range is really the long-term sustainable range that we expect from the asset class. I think this year we’ve had some operating expense challenges specifically with real-estate taxes that have sort of pulled back and made our expenses a little higher running a little higher than revenue. This year may be tough to be in that range certainly at the low end of anything but really I think it’s kind of building for next year and years ahead and some of the leasing activity and growing the revenue and certainly the SIP properties these development conversion properties will certainly help the growth profile of the same store portfolio in years ahead.

Jeff Gaston - KeyBanc

Great. Thanks a lot guys. That was all I had.

Todd Meredith

Thank you.

David Emery

Thank you.

Operator

And our next question comes from Michael Knott of Green Street Advisors. Please go ahead sir.

Michael Knott - Green Street Advisors

Hey good morning. Just a question on the expense side, just curious can you let us know if we are normalized now on the expense side after the noise from first quarter?

David Emery

Yes. So, I think we’re probably in the range now with the second quarter G&A is pretty much representative of the year. So that should be a good estimate.

Michael Knott - Green Street Advisors

In terms of the operating expenses some of the noise from first quarter due to the weather and some of the…

David Emery

Typically in the third quarter we’ll see again the seasonality with the summer our historical record over the past four, five, six years as third quarter property operating expenses specifically utilities tend the spike until and then it declines in the fourth quarter.

Michael Knott - Green Street Advisors

Okay. And then on the development conversion portfolio, can you just remind us what the incremental yield is, the target on the dollars that you spend on that and maybe what triggers property be included in that bucket? And then also is this portfolio going to continue to grow over the next few years or do you feel like it has set its size now and won't get any larger?

David Emery

The development conversion properties just 12 buildings in there those have been the same buildings for sometime well over a year and beyond that. So that group of properties really hasn't changed. We don’t have a plan to be adding to that other than if we start new project that will be in under construction.

So I think these properties you'll see roll into the portfolio next year so that's how those will transition in if we start new that would be construction in progress. And then also we had some redevelopment properties as you may see in our disclosures and those two certainly some of those will roll into the same store portfolio in the quarters and years ahead as well but not into the development conversion.

I know there is reposition will be potentially be candidates for sale as well.

Michael Knott - Green Street Advisors

And to the extent you're funding additional capital on those additional properties what kind of incremental return are you targeting?

David Emery

Well I think really look at the development target returns that we're looking for I think on the development conversions that you are speaking of we talked about $25 million to $30 million NOI level out of those properties. That gets us into the 6.5, 7 range on the capital spend on those that's been out there for a long time as you may know.

And then looking at new development projects I talked about in my prepared remarks 200 basis points over acquisition pricing. So depending on the leasing the initial leasing commitment. The mortgage we take the more return we expect and something closer to 100% lease it's going to closer through acquisition pricing. So that gives you a range for how we look at development.

Michael Knott - Green Street Advisors

Just one more that can you help you understand why the leasing percentage is still 10 points below your overall portfolio why is that kind of only picking up slowly? I know you expected to be 80%, 85% on the occupancy front by year-end, but I'm just curious about to understanding that.

David Emery

Well, the leasing at this point were down to as I mentioned about 185,000 feet and that spread out across also properties, but it really is concentrated in two properties. And so you've got the situation now where you're moving to having less space, you're asking, you're trying to push the rents. So we're being careful about leasing that space, we don't want to tore the ability to push rates throughout the building.

So it's got to be an evolution of some new leases, we're talking with some big hospitals prospects that a couple of the buildings were more of the spaces. And that just takes time, it's not a process that you can just keep that same 4%, 5% at quarter momentum that when you had a lot more space available. So it’s just a steady process that will take some time.

Doug Whitman

So while in the buildings really only have maybe 2,000, 3,000 square foot total empty spaces in them. So we've heard it call swift cheese effect such that if you have a larger user come to the building you may not have space to accommodate them anymore. That’s couple of properties, we still do but for the other 10, it's really just sort of filling in, in remaining holes of vacancy in the building either through expansion of existing tenants or when you find a tenants who is space in this match what we have. So it's not quite as Todd mentioned 4 to 5 percentage points per quarter and I think it's going to be a little bit more measure.

Michael Knott - Green Street Advisors

And then last one for me, can you just give any color on your recent leasing costs and any changes in trends there and then also is that something that we could possibly see in the supplemental going forward? Just disclosure on that. Thank you.

David Emery

The numbers on the releasing costs is something we certainly talk about in our 10-K each year. We think it's more appropriate to talk about on an annual basis course can balance around quarter-to-quarter. But general rule of thumb that we are seeing we don’t see any big trend or change in the trends lately is around $1 a foot per year of renewal or so. And then $2 a foot per year of renewal -- per year of leasing per new tenants. So that’s been a long term trend and we don’t see any particular change in that.

Michael Knott - Green Street Advisors

Thank you.

Operator

And our next question comes from Daniel Bernstein of Stifel. Please go ahead, sir.

Daniel Bernstein - Stifel

Good morning.

David Emery

Good morning Dan.

Daniel Bernstein - Stifel

Bethany was talking about all these positive catalysts for on campus MOBs, hospitals some of the trends that we know about, hiring more physicians forming ACOs all that. I am thinking in terms of what now should be the right stabilized occupancy for an MOB portfolio focusing on, on campus. I always used to think it was 90% to 92%. Is that something that should that be higher now, 92% to 95%? Just trying to think about how the occupancy -- if current trends continue can occupancy in the portfolio move up from this 90.5% range?

Doug Whitman

Dan as you know I have there for long time and I think it’s a little bit of what Doug mentioned. You get up into the upper 90s lower 90s, you really fall into a category where you do have the swift cheese, you have a little space down here and space over there and so on and so forth. So really it’s not as much a function of demand as it is as supply. So notwithstanding what you just said of the drivers, yes they are more, yes it increases and so on and so forth, but it’s just a practical functionality of it that notwithstanding the demand sometimes you just have smaller spaces, you have some space you are holding for expansion of another group because you don’t want to put that group in a position of looking elsewhere so on and so forth. So, I think that functional thing of 92%, 93% is probably the optimum, obviously we have some that are 100% so on and so forth.

So, it's not so much that the drivers are stronger now, so therefore occupancy is going to go up. It's just kind of a -- it's endogenous kind of issue regarding physical space.

And it's just like that natural level of unemployment never really goes at zero, just because there is people churning in a multitenant portfolio. There is a always churn of tenants who are moving, leaving a space and going upstairs, because it's bigger or vice versa or they are downsizing or they’re in expansion, or there's a retirement, there is always a churn going on that sort of kind of keeps a little bit of empty space available which as David pointed is beneficial, because if you are a 100% full and you have existing tenants who are looking for expansion or the hospital as recruited somebody to the campus, you got nowhere for them to go and so they look for other options.

So, to the extent that you can maintain a modest amount either by -- not really by design, but just you've always got that churn that a little bit of space or sort of access and buffer to provide opportunities for expansions and new tenants.

David Emery

Dan, also to expand on what Doug said is, part of it is, if you have a little bit of space and you have somebody who really, really needs it, you have a chance from a rate growth standpoint. So, you don't - to some degree, you always want to have some space to meet that non-sequitur demand that gives you the opportunity to push rates, because the last rate that you -- rate that you made in the building tends to wash over the renewals that are coming up in the following year. So, it's a balance of not necessarily 100% objective NOI, because then you basically under kind of contract agreement. So, it’s a balancing act.

Daniel Bernstein - Stifel

So maybe you could push to 95% occupancy if you want but that might hurt the future rate growth?

David Emery

Very good, yes.

Daniel Bernstein - Stifel

Okay.

Scott Holmes

Dan, when we underwrite (inaudible) just to putting some…

Daniel Bernstein - Stifel

Boil it down. And kind of related question, you talked a little bit about increasing number of modified gross and net leases, does that change? When you think about the hospital is becoming more prevalent tenants or bigger physician groups becoming more prevalent tenants in your facilities, are they looking more towards that modified growth or net lease -- is that what they want -- is it being driven by used, is it being driven somewhat by the tenants to move away from growth towards a net lease?

Unidentified Company Representative

Very much market driven Dan. I would say that in some cases for example where we have property tax expense challenges, we’ve certainly tried to mitigate some of that exposure where we had just gross leases. But it really does sort of depend on the market. And I would say there is just the nuances that some markets happen to be growth. But I’d say less and less you’d see that. I think the market is becoming a little bit more and some modified gross version of a lease structure or net lease.

David Emery

I think it’s driven by the bigger control by items then like utilities and taxes. Taxes seem to be a function, probably some of our most increases we’ve had in taxes and things that we can testing and litigating and otherwise wouldn’t probably surprises to be in taxes. That’s mainly because economy is booming and opinions, value are booming and so on and so forth. So I think that it’s probably -- it’s good that we try to cover those and particularly where you know that you got more exposure than you might have somewhere else.

Daniel Bernstein - Stifel

Okay. And then one last question here, I’ve been thinking more and more about the how to evaluate the hospital quality relative to the MOBs if you're doing due-diligence on properties, and talk about the stability of the hospital system. So what factors do you look at when considering or may be put them in order where most important one considering the stability of the hospital system relative to purchasing an MOB?

Unidentified Company Representative

I think the first thing you look at is the reputation, just the blink on who is this health system, what is their reputation in that market, then you get down to the specifics, investment grades; what's their credit rating; you look at the market share; you look at how things have changed for that help system, have they been in a net acquirer in expanding their business? So those are the things we look at. And certainly we tend to look at systems that are bigger than one hospital there. There may be they have 5, 10, 15 hospitals across the broad market, it's been on the size of the market. But it really comes down to can you comfortably say there are the top hospital or maybe they are neck and neck the top hospitals in that market.

Unidentified Company Representative

You can also talk to the physician tenant and get a pretty strong sense from them as to is the hospital management proactive and starting new programs, expanding new programs, recruiting people to the campus or are they focused elsewhere.

And so I think the physicians provide an excellent parameter sort of at least the near term, so where the vision of the hospital is going.

Daniel Bernstein - Stifel

Do you look at the hospital volumes at all?

Unidentified Company Representative

Somewhat, certainly look at baseline just sort of where they are on capacity and do they have a lot. Certainly one thing we want to make sure is we're not going to be on a campus where there is declining utilization and that you got. We want to see a situation were a hospital has been growing and expanding because of volume challenges and service lines been added as oppose to the offset.

Todd Meredith

But one other things Dan as you might expect there is a platform of information available on these hospitals. And we have a consultant in South Carolina that we use that basically any time, we look at the system, we're not really familiar with it. We can push a button and within probably three to four hours, we have unbelievable amount of information on the market for that hospitals stands. So also we rely upon, from standpoint systems, our forward composition has a lot of prime hospital experience only at like Dan Wilford from Memorial Hermann or Knox Singleton at Inova in Virginia. And they know a lot of these systems, they know a lot of the people, who were heading up these systems and so and so forth. So back to Todd’s original thing was is the reputation.

So a lot of time when we expose the Board and particular Board member to any initiative that we have or any new system or those kind of things and then they can use there own network of people that they know and report back us that we heard this, we heard that kind of along the line as Doug talking about. And so its kind like business in general, it's all about the people. So you want to make sure personally that you're hooking yourself at with forward-looking well respected organization.

Daniel Bernstein - Stifel

That's really good color. Thank you, David. That's all I have. Thank you.

Operator

And our next question comes from Lina Rudashevski of JPMorgan. Please go ahead.

Lina Rudashevski - JPMorgan

Hi. Thank you for taking my call. I was just wondering the development properties that were 82% leased, how long do you think it will take for those tenants to be rent paying and occupancy?

David Emery

The 82% leased that we talked about 80% to 85% occupancy by year end we are tracking certainly at the 80% level currently that could change as we progress through the year certainly by first quarter we should be certainly see that leasing convert to occupancy and in terms of rent paying we obviously give a run rate each certain tenant will have deferred rent component they might have free rent where that burns off over a few months. So that’s why we give that run rate you can understand not only the cash NOI but what it will be when they are paying full rents.

Lina Rudashevski - JPMorgan

Okay. Thanks. And then on disposition, can you talk about the timing of that for the rest of the year is it more 4Q? And then just on a recurring basis, do you think you will be selling more assets or scaling that down or?

David Emery

Sorry the first where you talking about the timing of disposition?

Doug Whitman

I would say they will be sprinkled through third and fourth quarters not really loaded one way or the other in we’ve given guidance range of about $40 million to $60 million I would expect probably something similar maybe a little bit higher next year.

David Emery

Yes that’s a pretty consistent range that we see year in, year out as that $50 million range and obviously we’ll adjust if we see something unique in our portfolio in the market.

Lina Rudashevski - JPMorgan

Okay, thank you.

Operator

And our next question comes from Todd Stender of Wells Fargo. Please go ahead, sir.

Todd Stender - Wells Fargo

Hi. Thanks. I just want to get some more details on your recent Minneapolis asset. It looks like it’s single tenant. It’s not representative of your multi-tenant strategy but just kind of looking at what the lease terms are, the cap rate and had that been multi-tenanted, what do you think the cap rate premium would have been?

David Emery

Well, I guess contrary to some of the other comments we've made. That is a multi-tenant building with a 100% lease. So, sorry to confuse on that. Anyway it's a 100% lease currently, it does have at least 6 tenants, there is an anchor tenant that little over 40%, 45% or so, the building of the primary care and the multi-specialty clinic.

Average lease terms, think are between six years and seven years for most of those tenant. So, it definitely fits our multi-tenant focus strategy there.

Todd Stender - Wells Fargo

Okay. I got confused. Sorry about that. And how about the cap rate?

Todd Meredith

Cap rate would be at the upper end of that 6.5% to 7%.

Todd Stender - Wells Fargo

Okay. And it looks like is that the asset you assumed $11 million of debt?

Todd Meredith

That's correct.

Todd Stender - Wells Fargo

Okay. And That's relatively high interest rate. How quickly can that be paid off?

Todd Meredith

20, 21 I think.

David Emery

Yes. It's got a couple of phases to unique that structure, but it is a little higher and certainly we want to see that, we'll repay that as we're able to over the next few years and Doug I think told me by early 2021.

Todd Stender - Wells Fargo

Okay. Thanks. And Doug it sounds like you remain active with issuing equity through the ATM and even some here in July. So it sounds like you've been match funding acquisitions throughout. With that kind of as a back drop, how are you thinking of your overall leverage right now? It's a little above 40% debt to cap. What's your current thoughts on leverage?

Doug Whitman

Well, we've indicated, we want to sort of keep that between 40% and 45%, last couple of quarters, we've been right in the mid-point of that. So, in general, I think we're pleased with that. Again, we've gotten some positive feedback from Moody's and SMP. So, we certainly want to be judicious and careful, where we will keep leverage, keep them happy. But again I think in general we’re fairly comfortable with where we are.

Todd Stender - Wells Fargo

Thanks. And just finally Todd, I think you have mentioned you’ve got a few more off campus assets that you’re looking to dispose of you’ve been pretty active with that. What do you think the volume is going to look like and how about timing of those transactions?

Todd Meredith

Well I think as Doug said, that’s probably fairly evenly throughout the rest of the year. Again I mentioned in my prepared remarks that probably we can -- what we’re seeing now is we could get to the upper end of that 40 to 50 range pretty quickly here this year and I think next year a similar range maybe higher would be our outlook right now.

Todd Stender - Wells Fargo

Okay. Thank you.

Todd Meredith

Sure.

Operator

And our next question comes from Karin Ford of KeyBanc. Please go ahead.

Jeff Gaston - KeyBanc

Hi. Jeff Gaston on here with Karin. Quick follow-up, have you been seeing any push back from tenants regarding your rising rents?

David Emery

No.

Jeff Gaston - KeyBanc

None?

David Emery

None.

Jeff Gaston - KeyBanc

All right. Thank you very much.

David Emery

Yes.

Operator

And our next question comes from William (inaudible) of Cowen and Company. Please go ahead.

Unidentified Analyst

Great thanks. If you could talk a bit about the purchase option in 2Q, was it $12 million payment that was difference between the purchase price and fair market value and when you modified the leases, were those marked up or down if you could just give a little more color on that?

David Emery

Yes. Bill these pretend to five properties that had an operating agreement the legacy structure, the only properties we have that. And it is really where they support the investment yield in exchange of certain controls and including those purchase options so we did reach an agreement to restructure to more traditional operating, standard operating structure and eliminating those favorable options in the process.

So that's the amount we paid with an agreed amount that we work out with the hospitals and really allows us to maintain long-term ownership of the property.

Unidentified Company Representative

But the underlying leases, Scott mentioned the support agreement between us and the health system but the actual leases with tenants were unaffected and untouched by this negotiation.

Unidentified Analyst

All right, okay. And then secondly just a book keeping question, when we kind of think about the recurring CapEx TI, as we usually take the real-estate additions and improvements in the quarter and we back out development conversion spend. And the second quarter that comes out to about 25 million less 5 million development conversion spend so that 20 -- 19 million, 20 million, right that seems, kind of how is there something else in there that I should be taking out?

Unidentified Company Representative

There is a little more going on in that number this quarter. If you recall the two Mercy projects account for fairly sizable number that we funded post closing for those two properties. So really when you kind of back out and then we have obviously as you said first generation space on the development conversion properties as well as a property that we acquired and had a tenant start in the second quarter with their lease, we were doing a large build out for them. So when you back all that out, you rally come down to a number that's more in the $9 million range or that number you're trying to get at for the quarter.

Unidentified Analyst

Okay, perfect. Thanks.

Unidentified Company Representative

Sure.

Operator

(Operator Instructions). And our next question comes from Michael Knott of Green Street Advisors. Please go head sir.

Michael Knott - Green Street Advisors

Hey guys just follow up on 40% to 45% target leverage. I'm just curious if you could you walk us through how you thought about that as the right range for your company. Thanks.

David Emery

Well, it just an opportunity on one hand there have enough leverage out there. So our cost of capital can be competitive as well other sourcing deals. But on the other hand as well keeping leverage modest such that we provide this flexibility should capital market is located again a few years ago to go any number of directions. If we needed to temporary level up some reason at the equity markets were displace, we have the capacity do so without too much difficulty. So I think again as report the ability to balance having an efficient cost of capital and effective cost of capital as well as providing a flexibility to source new investments out there.

Michael Knott - Green Street Advisors

Okay. Thanks.

Operator

And as there are no more questions, this will conclude question-and-answer session. I would now like to turn the conference back over to Mr. David Emery for any closing remarks.

David Emery

Very good. Thank you everyone for being on the call today. And I think everyone is going to be around here the rest of the day. So if we have any follow-up questions please give us a call. With that said, we will I guess recounting in November. Yes, it is. So have a good day.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.

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