COMPANIES & PEOPLE: Five questions for John Thomas

Physicians Realty Trust CEO credit relationships for recent flurry of acquisitions

By John B. Mugford

Coming off a remarkable 2016 in which Milwaukee-based Physicians Realty Trust (NYSE: DOC) acquired about $1.3 billion worth of healthcare facilities, mostly medical office buildings (MOBs), officers with the real estate investment trust (REIT) indicated they were not likely to keep up with such a pace in 2017.

At the start of 2017, the REIT, which has been led since its founding in June 2013 by John T. Thomas, president and CEO, estimated it would make investments totaling between $800 million and $1 billion in 2017.

However, in an industry where relationships mean a lot, the company has come across a number of investment opportunities in 2017 that were direct results of such relationships. During the first half of 2017, DOC made investments totaling $836.5 million. As a result of that total, as well as a number of additional significant acquisitions that either closed or were pending early in the second half of the year, the REIT changed its earlier year-end investment guidance for 2017 to $1.2 billion to $1.4 billion.

As an example of a relationship-driven acquisition, DOC in June and July closed on the purchase of 13 MOBs from Englewood, Colo.-based Catholic Health Initiatives (CHI) for $157.1 million. The 2017 CHI Portfolio purchase, as it is called by DOC, came on the heels of the REIT’s $700 million acquisition of more than 50 healthcare properties from CHI in 2016 for $700 million. That sale is widely regarded as the largest sale, or monetization, of MOBs by a health system in the history of the sector.

DOC has made other large deals resulting from relationships as well. Included in the REIT’s investment activities so far this year have been buildings that were originally slated to be part of the blockbuster deal of 2017, the acquisition by Scottsdale, Ariz.-based Healthcare Trust of America’s (NYSE: HTA) of nearly all of the MOBs in the portfolio owned by Indianapolis-based Duke Realty Corp. (NYSE: DRE), which exited the sector to focus on its industrial property division.

That $2.2 billion, 70-plus building transaction could have been larger – as high as $2.75 billion – if not for some properties that were subject to rights of first refusals (ROFRs). As it turned out, less than 20 MOBs were omitted from the HTA-Duke deal as a result of entities, namely health systems, exercising ROFRs and acquiring facilities from Duke Realty.

DOC, as it turns out, acquired four MOBs in two separate deals as a result of health systems exercising ROFRs.

In one of those, St. Vincent Health of Indianapolis acquired two MOBs from Duke Realty and subsequently sold them to Physicians Realty Trust for a total of $93.9 million. DOC’s Deeni Taylor, executive VP and chief investment officer, spent about 13 years with St. Vincent as an executive from 1992 to 2005, when he joined Duke Realty’s then-emerging healthcare real estate (HRE) group.

In another ROFR deal, Northside Hospital in Atlanta acquired two properties with three MOBs and developable land from Duke Realty and subsequently entered agreements to sell them to DOC for $194 million. As of mid-August, DOC had closed on one of those properties for $38 million while the $156 million sale of another property, the 363,174 square foot Northside Center Pointe I and II MOB complex in Atlanta, was still pending.

Mr. Taylor and James D. “Jim” Bremner, who was the leader of Duke Realty’s healthcare division from 2007 through 2015, were leaders at Duke Realty when the firm acquired the Atlanta properties in 2007. Mr. Bremner, who retired from Duke Realty in 2015, recently started a new firm, Indianapolis-based Bremner Real Estate, which is focused on MOB developments and which provided consulting services to DOC in the recent ROFR acquisitions.

“Jim (Bremner) consulted with us on the deal and helped us work through these ROFRs, and the hospitals were reaching out to him as well,” Mr. Thomas says. “He’s restarting his own healthcare development firm, much like the one he originally had and sold to Duke Realty (in 2007). He’ll stay independent, but for the projects that he develops on his own, we’ll work with him in supplying capital or buying them after they’re completed.”

DOC’s largest purchase that could have been part of the HTA-Duke deal involved the Charles A. Sammons Baylor Cancer Center on the campus of Baylor University Medical Center in Dallas. Duke Realty owned 16 percent of that building, with Milwaukee-based Northwestern Mutual Life Insurance Co. owning the remaining 84 percent.

When Duke Realty decided to sell its MOB portfolio and thereby exit the HRE sector, Northwestern Mutual and Duke Realty offered both of their ownership shares to DOC, which acquired the property in late June for $290 million. While with Duke Realty, Messrs. Taylor and Bremner led the development of the 10-story, 458,396 square foot facility for what is now Baylor Scott & White Health.

In addition, Mr. Thomas was previously with what is now Baylor Scott & White Health as senior VP-general counsel through 2005.

During what was shaping up to be a busy start to the second half of 2017, we caught up with Mr. Thomas.

1.) In regard to the Duke Realty portfolio, was Physicians Realty Trust in the running for the purchase?

Yes, we pursued it. It was very competitive and we were way behind on the purchase price, even though we considered the deal to be of very high quality. But in the end, we feel like we ended up with five of the high-quality assets that were in the deal.

2.) The CHI transaction in June 2016 for $130 million was interesting after you acquired the large, $700 million
portfolio from the health system in 2016. Is the most recent purchase a reflection of the relationship established with CHI last year? And, do you foresee more acquisitions from that health system?

Yes, it is a reflection of the relationship established there. It’s gone very well and they are very happy about what we’ve been able to come in and do with that portfolio. We’ve already made some significant improvements in buildings and occupancies. I’m not sure there’s a whole lot more to do with them, even though we are open to doing some more with CHI.  We do like to be careful about having a lot of concentration with one tenant. We’re up to well over $800 million with them, closing in on $900 million, which is certainly a big number. But the credit is all divided up by market, so that’s a way to look at it in terms of not being overly concentrated. But the relationship
with them has gone very well, and it is an interesting relationship that could have a different look should CHI and (San Francisco-based) Dignity Health continue looking at a merger. We have some properties that are indirectly affiliated with Dignity, but this would certainly start and increase a relationship with them.

3.) Let’s talk about the acquisitions DOC made from St. Vincent in Indianapolis, Northside in Atlanta and of the Baylor Cancer Center in Dallas. How did those come about and did relationships play a part in those as well?

Yes, relationships played a big role. They were all buildings that Deeni Taylor and Jim Bremner had developed or acquired for those hospital systems while they were with Duke Realty, which had acquired Jim’s firm. These are buildings that are very critical to those hospital systems and that were important to them and they wanted to have Deeni and Jim involved for a reason, as they had helped develop the buildings and the health systems felt comfortable with them. And that’s nothing negative to any other potential owner of those buildings; it’s just that
they reached out to Deeni and Jim, through us and Jim’s new consulting firm, and were interested in working with them in exercising the ROFRs.

As for the Baylor Cancer Center, while it was somewhat similar, what was different was that Northwestern Mutual owned 84 percent of that building. So what Duke had to sell was their 16 percent, and the life company approached us if we wanted to buy the 16 percent or the whole thing. Because they had the right to sell us everything, even though Baylor had a ROFR on that entire interest as well. So the life insurance company had the right to buy the 16 percent that Duke was selling and then the life insurance company wanted to sell the building, so we ended up working with Baylor and Northwestern Mutual. So they waived the ROFR. In that case, Deeni and Jim Bremner had developed the building for Baylor. The fact that Deeni and myself have worked for health systems in the past really distinguishes us in the market. We’ve acquired about a billion dollars worth of buildings so far this year and virtually all of them have been relationship driven, either having somebody on the team working for a system or having had past client relationship with them. In this situation, we wouldn’t suggest anything negative
about HTA by any means, but the health systems just knew us and wanted to work with us and wanted to exercise the ROFRs. Any time there’s a deal this big, perhaps some ROFRs would be exercised no matter who the buyer is. As an example, Baylor could’ve exercised a number of ROFRs in those assets and were perfectly happy having HTA acquire those buildings.

4.) Based on MOB sector averages, the cap rates were quite low on your ROFR purchases, being listed by your company at 4.7 percent. Is that lower than you typically would be willing to go?

We were certainly transparent on those cap rates and disclosed them, and yes, they are lower than what we’ve done
before and what we would normally want to do. But they all have very long-term, very high IRRs (internal rates of returns), and that’s a reflection of the quality of the buildings, their locations and the credit behind each of them. But they are part of a larger transaction that traded at a cap rate that we would estimate at being a little bit tighter than 4.7 percent. But we felt more comfortable with that type of cap rate because we received lease enhancements in at least three of the buildings.

So, with what we bought and paid, we actually got better than what we could’ve gotten by buying them directly from Duke Realty because of the lease enhancements that came with the health systems inviting us to work with them. We also got some development rights related to the Northside Hospital property in Atlanta, so the cap rate didn’t fully reflect all of what we got out of the deal. These were cash deals and we were
stepping into the contract that HTA agreed to with Duke, so whatever the terms of that deal were is what we stepped into.

5.) You’ve been acquiring at a rapid pace of late. Do you see Physicians Realty Trust keeping up that pace? And, are there still opportunities for you out in the market, including health system monetizations?

There are lots of opportunities. We had essentially given guidance to acquiring $800 million to $1 billion for 2017. We’ve already gotten close to a billion and will exceed that figure, so we’ve raised our guidance to, at the top end, $1.4 billion. And we’re thinking that that number is pretty likely. The market has pulled back lately, with the MOB REITs having pulled back in the last couple of weeks with the 10-year Treasury going up and the jobs report from last week being strong, which drives the market towards increasing interest rates. There’s always a short term correlation between rising interest rates and REIT equities, and healthcare REITs, with longer lease terms, get hit disproportionately.

But, overall the market is still strong and favors healthcare REITs and we still have a favorable cost of capital and there is plenty of assets on the market. Even though the Duke deal has certainly raised seller expectations concerning price, we’re still apt to get a good spread to our cost of capital. So, we’ll see how pricing plays out because we still have a good pipeline for the rest of the year. We’re long-term holders but we have to have a cost of capital that makes sense.

Demand is very strong right now, but there is and should continue to be a good amount of product out there. As for monetizations, I think there will be some one-off deals from the health systems, perhaps some more ROFR deals where they have the rights to buildings and pass on them in order to sell to buyers like us. But for the time being, I could see some more one-offs and maybe some smaller portfolios from the health systems. But I don’t know of any big portfolio deals from a health system like that one happening anytime soon.