UNIVERSAL HEALTH REALTY INCOME TRUST annual report, FY2016

Business context and reporting period

Universal Health Realty Income Trust is a Maryland healthcare-focused REIT. This Form 10-K covers the fiscal year ended December 31, 2016; the filing also presents fourth-quarter and full-year comparative information. As of February 28, 2017, the portfolio comprised 67 investments or commitments in 20 states: six hospitals, 54 medical office buildings, three freestanding emergency departments and four preschool/childcare centers.

The Trust is externally advised by UHS of Delaware, Inc., a subsidiary of Universal Health Services, Inc. (UHS). The Trust had no salaried employees at December 31, 2016, and its officers were UHS employees.

Financial performance and key metrics

Metric	2016	2015	Change
Total revenue	$67.1 million	$64.0 million	+4.9%
Net income	$17.2 million	$23.7 million	-27.4%
Basic and diluted EPS	$1.28	$1.78	-28.1%
Funds from operations	$41.6 million	$38.3 million	+8.4%
FFO per diluted share	$3.09	$2.88	+7.3%
Cash flow from operations	$40.7 million	$38.2 million	+6.7%
Dividends paid	$35.1 million	$34.1 million	+3.1%

Calculated margins were approximately 25.7% for net income and 62.0% for FFO in 2016. These are derived metrics and should be considered in light of the Trust’s REIT structure and substantial depreciation and amortization.

Revenue consisted primarily of base rent from UHS facilities of $16.3 million, base rent from non-related parties of $37.1 million, UHS bonus rent of $4.7 million, and tenant reimbursements and other revenue of $9.0 million. Equity income from unconsolidated LLCs increased to $4.5 million from $2.5 million.

At December 31, 2016, total assets were $524.8 million, net real estate investments were $447.2 million, total equity was $191.3 million and total indebtedness, including debt premium, was approximately $315.7 million. Debt represented approximately 60% of total assets on a calculated basis.

Liquidity, debt and cash flow

• Operating cash flow was $40.7 million, compared with $38.2 million in 2015.
• Investing cash outflows were $74.8 million, including $60.4 million for four medical office building acquisitions, $11.2 million for real estate additions and $5.5 million of investments in unconsolidated LLCs.
• Financing cash inflows were $34.1 million, including $59.4 million of additional revolving-credit borrowings and $13.5 million of net equity issuance proceeds.
• The $250 million revolving credit facility had $201.5 million outstanding, $2.7 million of letters of credit and $45.8 million of available capacity at year-end. It matures in March 2019 and includes a one-year extension option.
• Non-recourse mortgage debt totaled $114.2 million, with approximately $61.1 million of scheduled consolidated debt repayments in 2017 and $205.3 million in 2019, including repayment of the revolving credit balance if not refinanced.
• Management stated that operating cash flows, cash, available credit and capital-market access were expected to provide sufficient resources for the next 12 months, while cautioning that financing may not be available on acceptable terms.
• The Trust was in compliance with all credit agreement covenants. Reported ratios included total leverage of 48.6% against a less-than-60% limit and fixed-charge coverage of 3.6x against a greater-than-1.50x requirement.

Material changes versus the prior comparable period

• Revenue increased $3.1 million, primarily from 2016 medical office building acquisitions and higher revenue at other properties.
• Net income declined because 2015 included an $8.7 million gain on a property exchange. Interest expense also increased by $1.1 million, partly due to additional acquisition borrowings and the refinancing of an unconsolidated LLC’s mortgage with Trust borrowings.
• FFO increased despite the lower GAAP net income, reflecting higher property income and increased depreciation and amortization add-backs.
• The Trust acquired four MOBs for approximately $67.5 million of aggregate purchase price, including assumed non-recourse debt on 2704 North Tenaya Way. The properties were Madison Professional Office Building, Chandler Corporate Center III, Frederick Crestwood MOB and 2704 North Tenaya Way.
• The Trust invested $9.5 million through year-end in the Henderson Medical Plaza, a 78,800-square-foot MOB scheduled to open in the first quarter of 2017, with a total development commitment of up to $21.1 million.
• UHS exercised five-year renewal options for the three acute-care hospital leases, extending them at existing lease rates through December 2021.
• During 2016, the Trust issued 249,016 shares under its ATM program, generating approximately $13.2 million of net proceeds. Approximately $9.5 million of gross issuance capacity remained at year-end.
• Annual dividends increased to $2.60 per share from $2.56. The filing states that $2.00 per share represented ordinary income and $0.60 represented return of capital for 2016 tax purposes.

Outlook, commentary, risks and unusual items

The filing provides no formal earnings or FFO guidance. Management expects to fund capital expenditures, acquisitions and dividends through operating cash flow, cash, revolving-credit borrowings, mortgage financing and equity issuance, but does not guarantee capital-market availability or future dividend levels.

• UHS-related leases represented approximately 33% of consolidated revenue in 2016; the three UHS acute-care hospital leases represented approximately 24%. UHS also serves as the Trust’s advisor and provides all officers, creating concentration and related-party conflict risks.
• UHS has purchase options and rights of first refusal on certain hospitals and freestanding emergency departments. Exercise of these options or non-renewal of leases could reduce future rental income.
• Healthcare reimbursement, Medicare and Medicaid funding, possible changes to the Affordable Care Act, value-based purchasing and regulatory compliance could affect tenants’ operating results and ability to pay rent.
• Hospital occupancy remained uneven. 2016 occupancy was 47% at McAllen Medical Center, 55% at Wellington Regional, 64% at Inland Valley, 75% at HealthSouth Deaconess, 51% at Vibra Corpus Christi and 46% at Kindred Chicago Central.
• MOB lease renewals executed in 2016 represented approximately 10% of rentable square feet, and renewal rental rates declined approximately 3% versus the expired leases. Portfolio-level lease expirations represent approximately 11% of total rentable square feet in 2017 and 9% in 2018.
• The Trust holds non-controlling interests in five unconsolidated LLCs/LPs. These entities had $28.4 million of non-recourse third-party debt at year-end, and the Trust had $1.1 million of remaining equity and debt financing commitments.
• Variable-rate debt creates interest-rate exposure. The filing estimates that a 1% change in interest rates would affect net income by approximately $2.2 million after giving effect to interest-rate caps.
• 2016 included $528,000 of transaction costs. No divestitures or impairment charges were reported in 2016. The 2015 and 2014 comparisons were affected by significant property-exchange, minority-interest and property-divestiture gains.
• The Trust renewed its UHS advisory agreement for 2017 at the same terms. Advisory fees were $3.3 million in 2016, and no incentive fee was paid.

Most important facts for investors to verify

• Verify the timing and terms of refinancing for approximately $61.1 million of 2017 debt maturities and the $201.5 million revolving-credit balance due in 2019.
• Monitor UHS financial condition, lease renewals, purchase options and the effect of UHS concentration on rental revenue.
• Assess occupancy, lease expirations, renewal spreads and tenant concentration across the MOB portfolio.
• Review the opening, lease-up and total cost of the Henderson Medical Plaza.
• Reconcile GAAP net income with FFO and distinguish recurring property earnings from non-recurring gains and transaction costs.
• Review unconsolidated LLC obligations, member-loan maturities and the Trust’s remaining financing commitments.
• Evaluate exposure to healthcare reimbursement changes, regulatory actions, labor costs, tenant defaults and interest-rate movements.