UNIVERSAL HEALTH REALTY INCOME TRUST annual report, FY2015

Business Context and Reporting Period

Universal Health Realty Income Trust is a Maryland healthcare-focused REIT reporting on the fiscal year ended December 31, 2015. It owned or invested in 62 healthcare and human-service properties across 18 states as of February 29, 2016, including six hospitals, 49 medical office buildings, three free-standing emergency departments and four childcare centers. The Trust operates as a single reportable segment and relies on UHS of Delaware, Inc., a subsidiary of Universal Health Services, Inc. (UHS), for advisory and administrative services.

Key Financial Metrics

Metric	2015	2014	Change
Total revenue	$63.95 million	$59.79 million	Reported increase of 7.0%; approximately 0.9% increase on an adjusted comparable basis
Net income	$23.69 million	$51.55 million	Decrease of $27.86 million
Basic and diluted EPS	$1.78	$3.99	Decrease of $2.21
Funds from operations	$38.35 million	$35.94 million	Increase of 6.7%
Adjusted FFO	$38.59 million	$36.36 million	Increase of 6.1%
Cash flow from operations	$38.18 million	$32.80 million	Increase of $5.38 million
Dividends paid	$34.09 million	$32.72 million	Increase of $1.37 million
Net real estate investments	$390.50 million	$380.11 million	Increase of $10.39 million
Total assets	$458.90 million	$428.87 million	Increase of $30.04 million
Total indebtedness	$252.70 million	$213.16 million	Increase of $39.55 million

Reported net margin was approximately 37.0%, compared with 86.2% in 2014; the comparison is distorted by nonrecurring gains in both years. Income before equity income, interest and gains was $20.64 million, or approximately 32.3% of revenue. FFO was approximately $2.88 per diluted share, compared with $2.78 in 2014. The filing does not provide a clear comparable same-property operating margin.

Material Changes Versus the Prior Comparable Period

Revenue increased primarily from properties acquired in 2014 and 2015, including the Haas Medical Office Park, two Texas free-standing emergency departments and two Georgia medical office buildings received in a property exchange.
Net income declined because 2014 included a $25.4 million gain from purchasing minority interests in eight LLCs and a $13.0 million gain on the sale of The Bridgeway. These gains did not recur in 2015.
2015 included an $8.7 million gain on a property exchange involving Sheffield Medical Building and two Georgia medical office buildings.
FFO and adjusted FFO increased because of higher property-level income, contributions from acquired properties and lower interest expense, partially offset by higher depreciation and amortization.
The Trust acquired three medical office buildings and two free-standing emergency departments for approximately $16.8 million of net cash and invested $5.3 million in real estate additions, primarily tenant improvements.
Investing cash use increased to $44.3 million from $4.0 million, largely because of a $22.8 million member loan to Arlington Medical Properties and property acquisitions.
Financing activities provided $6.2 million in 2015 versus using $29.8 million in 2014. Revolving credit borrowings increased by $52.4 million, while dividends paid increased to $34.1 million.
Medical office building lease renewals executed in 2015 had weighted-average rental rates approximately 3% below the rates on the expired leases.

Debt, Liquidity and Capital Resources

The Trust entered into a new $185 million revolving credit facility maturing in March 2019, with a one-year extension option and a potential $50 million expansion option subject to lender approval.
At December 31, 2015, revolving credit borrowings were $142.2 million, letters of credit were $3.5 million and available borrowing capacity was $39.3 million. The applicable LIBOR margin was 1.625% and the commitment fee was 0.25%.
Fourteen non-recourse mortgages had an aggregate balance of approximately $110.3 million, excluding debt premium. Consolidated debt maturities included approximately $13.7 million in 2016, $50.6 million in 2017, $22.8 million in 2018 and $145.8 million in 2019, including the revolving facility balance.
Liquidity included $3.9 million of cash and cash equivalents, $38.2 million of operating cash flow and $39.3 million of unused revolver capacity at year-end.
Management stated that operating cash flow, cash, available borrowing capacity, the $100 million securities registration capacity and capital-market access should be sufficient for the next twelve months, including REIT distribution requirements. The filing cautions that financing may not be available on acceptable terms.
The Trust was in compliance with all revolving-credit covenants. Reported covenant metrics included total leverage of 45.0%, secured leverage of 19.8%, unencumbered leverage of 42.2% and fixed-charge coverage of 3.3x.

Outlook, Commentary, Risks and Unusual Items

No formal earnings or revenue guidance was provided.
Three UHS acute-care hospital leases, representing approximately 25% of consolidated revenue in 2015, were scheduled to expire in December 2016. UHS has renewal and purchase options, and the Trust cannot assure renewal at existing rates.
UHS accounted for approximately 33% of consolidated revenue in 2015 when hospital, medical office and other UHS-related leases are considered. UHS also owns 5.9% of the Trust and provides its advisory services, creating concentration and related-party risks.
The advisory agreement was renewed for 2016 on the same terms. The advisory fee was 0.70% of average invested real estate assets, or $2.8 million in 2015. No incentive fee was earned in 2015, 2014 or 2013.
Healthcare reimbursement changes, Medicare sequestration, Medicaid funding pressure, the Affordable Care Act, value-based purchasing, private-payor rate pressure and operator compliance failures could reduce tenants’ ability to pay rent and could lower bonus rents.
Competition, labor shortages, physician and staff retention, declining hospital volumes, medical office vacancies, lease rollover and unfavorable renewal terms may pressure property income and valuations.
Variable-rate debt creates interest-rate exposure. The filing estimates that a 1% change in applicable rates would affect net income by approximately $1.7 million based on variable-rate debt outstanding at year-end.
Non-controlling investments in five LLCs and LPs generated $2.5 million of equity income in 2015. The Trust advanced $22.8 million to Arlington Medical Properties after its mortgage matured and had $2.2 million of remaining equity and debt financing commitments.
The Trust maintained REIT status, paid $2.56 per share of dividends in 2015 and reported that $2.17 was ordinary income and $0.39 was a return of capital.
KPMG issued an unqualified audit opinion on the financial statements and internal control over financial reporting. Management reported effective disclosure controls and internal controls, with no unresolved SEC staff comments or material legal proceedings.

Investor Verification Priorities

Verify the status, renewal terms and rent economics of the three UHS acute-care hospital leases expiring in December 2016, including any purchase-option activity.
Reconcile recurring FFO and adjusted FFO to reported net income and exclude the $8.7 million property-exchange gain when assessing sustainable earnings.
Review the $142.2 million revolver balance, the March 2019 maturity and the ability to refinance or repay the debt while maintaining dividends.
Assess UHS tenant and counterparty concentration, including the advisory relationship and related-party lease transactions.
Monitor occupancy, lease expirations and renewal spreads across medical office buildings, particularly the 2016 rollover exposure.
Evaluate the $22.8 million Arlington Medical Properties member loan, the remaining $2.2 million of investment commitments and non-recourse debt at unconsolidated affiliates.
Confirm the tax characterization and sustainability of the $2.56 per-share dividend, including the portion classified as return of capital.