10-K 1 d834449d10k.htm UNIVERSAL HEALTH REALTY INCOME TRUST--FORM 10-K Universal Health Realty Income Trust--Form 10-K
Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

x    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2014

 

OR

 

¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                     to                     

 

Commission File No. 1-9321

 

UNIVERSAL HEALTH REALTY INCOME TRUST

 

(Exact name of registrant as specified in its charter)

 

Maryland   23-6858580

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

Universal Corporate Center

367 South Gulph Road

P.O. Box 61558

King of Prussia, Pennsylvania

 

19406-0958

(Zip Code)

(Address of principal executive offices)  

 

Registrant’s telephone number, including area code: (610) 265-0688

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each Class

Shares of beneficial interest, $.01 par value

 

Name of each exchange on which registered

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

Yes  ¨    No  x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

Yes  ¨    No  x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  x    No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Yes  x    No  ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨   Smaller reporting company  ¨
      (Do not check if a smaller

reporting company)

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act) Yes  ¨    No  x

 

Aggregate market value of voting shares and non-voting shares held by non-affiliates as of June 30, 2014: $555,012,765 (For the purpose of this calculation only, all members of the Board of Trustees are deemed to be affiliates). Number of shares of beneficial interest outstanding of registrant as of January 31, 2015: 13,301,298

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive proxy statement for our 2015 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2014 (incorporated by reference under Part III).

 

 

 


Table of Contents

UNIVERSAL HEALTH REALTY INCOME TRUST

2014 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

PART I   

Item 1

 

Business

     1   

Item 1A

 

Risk Factors

     9   

Item 1B

 

Unresolved Staff Comments

     19   

Item 2

 

Properties

     20   

Item 3

 

Legal Proceedings

     26   

Item 4

 

Mine Safety Disclosures

     26   
PART II   

Item 5

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     26   

Item 6

 

Selected Financial Data

     28   

Item 7

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     31   

Item 7A

 

Quantitative and Qualitative Disclosures About Market Risk

     51   

Item 8

 

Financial Statements and Supplementary Data

     52   

Item 9

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     52   

Item 9A

 

Controls and Procedures

     52   

Item 9B

 

Other Information

     55   
PART III   

Item 10

 

Directors, Executive Officers and Corporate Governance

     55   

Item 11

 

Executive Compensation

     55   

Item 12

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     55   

Item 13

 

Certain Relationships and Related Transactions, and Director Independence

     55   

Item 14

 

Principal Accountant Fees and Services

     55   
PART IV   

Item 15

 

Exhibits and Financial Statement Schedules

     56   

SIGNATURES

     58   

Index to Financial Statements and Schedule

     59   

Exhibit Index

     94   

Exhibit 10.2—Advisory Agreement renewal

  

Exhibit 21—Subsidiaries of Registrant

  

Exhibit 23.1—Consent of KPMG LLP

  

Exhibit 31.1—Section 302 Certification of the Chief Executive Officer

  

Exhibit 31.2—Section 302 Certification of the Chief Financial Officer

  

Exhibit 32.1—Section 906 Certification of the Chief Executive Officer

  

Exhibit 32.2—Section 906 Certification of the Chief Financial Officer

  


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This Annual Report on Form 10-K is for the year ended December 31, 2014. This Annual Report modifies and supersedes documents filed prior to this Annual Report. Information that we file with the Securities and Exchange Commission (the “SEC”) in the future will automatically update and supersede information contained in this Annual Report. In this Annual Report, “we,” “us,” “our” and the “Trust” refer to Universal Health Realty Income Trust and its subsidiaries.

 

As disclosed in this Annual Report, including in Part I, Item 1.-Relationship with Universal Health Services, Inc. (“UHS”), a wholly-owned subsidiary of UHS (UHS of Delaware, Inc.) serves as our Advisor pursuant to the terms of an annually renewable Advisory Agreement dated December 24, 1986. Our officers are all employees of UHS through its wholly-owned subsidiary, UHS of Delaware, Inc. In addition, three of our hospital facilities are leased to subsidiaries of UHS and thirteen medical office buildings, including certain properties owned by limited liability companies in which we either hold 100% of the ownership interest or various non-controlling, majority ownership interests, include or will include tenants which are subsidiaries of UHS. Any reference to “UHS” or “UHS facilities” in this report is referring to Universal Health Services, Inc.’s subsidiaries, including UHS of Delaware, Inc.

 

In this Annual Report, the term “revenues” does not include the revenues of the unconsolidated limited liability companies (“LLCs”) in which we have various non-controlling equity interests ranging from 33% to 95%. We currently account for our share of the income/loss from these investments by the equity method (see Note 8 to the Consolidated Financial Statements included herein).


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PART I

 

ITEM 1. Business

 

General

 

We are a real estate investment trust (“REIT”) which commenced operations in 1986. We invest in health care and human service related facilities currently including acute care hospitals, rehabilitation hospitals, sub-acute facilities, surgery centers, free-standing emergency departments, childcare centers and medical office buildings (“MOBs”). As of February 28, 2015 we have sixty-one real estate investments or commitments located in eighteen states in the United States consisting of: (i) six hospital facilities including three acute care, one rehabilitation and two sub-acute; (ii) forty-eight MOBs; (iii) three free-standing emergency departments, and; (iv) four preschool and childcare centers.

 

Available Information

 

We have our principal executive offices at Universal Corporate Center, 367 South Gulph Road, King of Prussia, PA 19406. Our telephone number is (610) 265-0688. Our website is located at http://www.uhrit.com. Copies of the annual, quarterly and current reports we file with the SEC, and any amendments to those reports, are available free of charge on our website. Additionally, we have adopted governance guidelines, a Code of Business Conduct and Ethics applicable to all of our officers and directors, a Code of Ethics for Senior Officers and charters for each of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of the Board of Trustees. These documents are also available free of charge on our website. Copies of such reports and charters are available in print to any shareholder who makes a request. Such requests should be made to our Secretary at our King of Prussia, PA corporate headquarters. We intend to satisfy the disclosure requirement under Item 5.05 of Form 8-K relating to amendments to or waivers of any provision of our Code of Ethics for Senior Officers by promptly posting this information on our website. The information posted on our website is not incorporated into this Annual Report.

 

In accordance with Section 303A.12(a) of The New York Stock Exchange Listed Company Manual, we submitted our CEO’s Certification to the New York Stock Exchange in 2014. Additionally, contained in Exhibits 31.1 and 31.2 of this Annual Report are our CEO’s and CFO’s certifications regarding the quality of our public disclosure under Section 302 of the Sarbanes-Oxley Act of 2002.

 

Overview of Facilities

 

As of February 28, 2015, we have investments in sixty-one facilities, located in eighteen states and consisting of the following:

 

Facility Name

  Location   Type of Facility   Ownership   Guarantor

Southwest Healthcare System, Inland Valley Campus(A)

  Wildomar, CA   Acute Care   100%   Universal Health Services, Inc.

McAllen Medical Center(A)

  McAllen, TX   Acute Care   100%   Universal Health Services, Inc.

Wellington Regional Medical Center(A)

  W. Palm Beach, FL   Acute Care   100%   Universal Health Services, Inc.

Kindred Hospital Chicago Central(B)

  Chicago, IL   Sub-Acute Care   100%   Kindred Healthcare, Inc.

Vibra Hospital of Corpus Christi(B)

  Corpus Christi, TX   Sub-Acute Care   100%   Kindred Healthcare, Inc.

HealthSouth Deaconess Rehabilitation Hospital(F)

  Evansville, IN   Rehabilitation   100%   HealthSouth Corporation

Family Doctor’s Medical Office Bldg.(B)

  Shreveport, LA   MOB   100%   Christus Health Northern Louisiana

Kelsey-Seybold Clinic at Kings Crossing(B)

  Kingwood, TX   MOB   100%   Kelsey-Seybold
Medical Group, PLLC

Professional Bldgs. at Kings Crossing Building A(B)

  Kingwood, TX   MOB   100%  

Building B(B)

  Kingwood, TX   MOB   100%  

Chesterbrook Academy(B)

  Audubon, PA   Preschool & Childcare   100%   Nobel Learning Comm. & Subs.

 

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Facility Name

  Location   Type of Facility   Ownership   Guarantor

Chesterbrook Academy(B)

  New Britain, PA   Preschool & Childcare   100%   Nobel Learning Comm. & Subs.

Chesterbrook Academy(B)

  Newtown, PA   Preschool & Childcare   100%   Nobel Learning Comm. & Subs.

Chesterbrook Academy(B)

  Uwchlan, PA   Preschool & Childcare   100%   Nobel Learning Comm. & Subs.

Southern Crescent Center I(B)

  Riverdale, GA   MOB   100%  

Southern Crescent Center, II(D)

  Riverdale, GA   MOB   100%  

Suburban Medical Plaza II(C)

  Louisville, KY   MOB   33%  

Desert Valley Medical Center(E)

  Phoenix, AZ   MOB   100%  

Cypresswood Professional Center(B) 8101

  Spring, TX   MOB   100%  

8111

  Spring, TX   MOB   100%  

Desert Springs Medical Plaza(D)

  Las Vegas, NV   MOB   100%  

701 South Tonopah Bldg.(A)

  Las Vegas, NV   MOB   100%  

Santa Fe Professional Plaza(E)

  Scottsdale, AZ   MOB   100%  

Sheffield Medical Building(B)

  Atlanta, GA   MOB   100%  

Summerlin Hospital MOB I(D)

  Las Vegas, NV   MOB   100%  

Summerlin Hospital MOB II(D)

  Las Vegas, NV   MOB   100%  

Medical Center of Western Connecticut(B)

  Danbury, CT   MOB   100%  

Mid Coast Hospital MOB(C)

  Brunswick, ME   MOB   74%  

Rosenberg Children’s Medical Plaza(E)

  Phoenix, AZ   MOB   100%  

Gold Shadow(D)

       

700 Shadow Lane MOB

  Las Vegas, NV   MOB   100%  

2010 & 2020 Goldring MOBs

  Las Vegas, NV   MOB   100%  

St. Mary’s Professional Office Building(C)

  Reno, NV   MOB   75%  

Apache Junction Medical Plaza(E)

  Apache Junction, AZ   MOB   100%  

Spring Valley Medical Office Building(E)

  Las Vegas, NV   MOB   100%  

Spring Valley Hospital Medical Office Building II(D)

  Las Vegas, NV   MOB   100%  

Sierra San Antonio Medical Plaza(E)

  Fontana, CA   MOB   100%  

Phoenix Children’s East Valley Care Center(E)

  Phoenix, AZ   MOB   100%  

Centennial Hills Medical Office Building(D)

  Las Vegas, NV   MOB   100%  

Palmdale Medical Plaza(D)

  Palmdale, CA   MOB   100%  

Summerlin Hospital Medical Office Building III(D)

  Las Vegas, NV   MOB   100%  

Vista Medical Terrace(D)

  Sparks, NV   MOB   100%  

The Sparks Medical Building(D)

  Sparks, NV   MOB   100%  

Auburn Medical Office Building II(E)

  Auburn, WA   MOB   100%  

Texoma Medical Plaza(G)

  Denison, TX   MOB   95%  

BRB Medical Office Building(E)

  Kingwood, TX   MOB   100%  

North Valley Medical Plaza(E)

  Phoenix, AZ   MOB   100%  

Lake Pointe Medical Arts Building(E)

  Rowlett, TX   MOB   100%  

Forney Medical Plaza(E)

  Forney, TX   MOB   100%  

Tuscan Professional Building(E)

  Irving, TX   MOB   100%  

Emory at Dunwoody Building(E)

  Atlanta, GA   MOB   100%  

PeaceHealth Medical Clinic(E)(H)

  Bellingham, WA   MOB   100%  

Forney Medical Plaza II(J)

  Forney, TX   MOB   95%  

Northwest Texas Professional Office Tower(E)

  Amarillo, TX   MOB   100%  

5004 Poole Road MOB(A)

  Denison, TX   MOB   100%  

Ward Eagle Office Village(E)

  Farmington Hills, MI   MOB   100%  

The Children’s Clinic at Springdale(E)

  Springdale, AR   MOB   100%  

The Northwest Medical Center at Sugar Creek(E)

  Bentonville, AR   MOB   100%  

Hanover Emergency Center (E)(K)

  Mechanicsville, VA   Free-standing
Emergency
  100%  

Weslaco Free-standing Emergency Department(L)

  Weslaco, TX   Free-standing
Emergency
  100%  

Mission Free-standing Emergency Department(L)

  Mission, TX   Free-standing
Emergency
  100%  

Haas Medical Office Park (E)(I)

  Ottumwa, IA   MOB   100%   Regional Hospital Partners

 

(A) Real estate assets owned by us and leased to subsidiaries of Universal Health Services, Inc. (“UHS”).
(B) Real estate assets owned by us and leased to an unaffiliated third-party or parties.
(C) Real estate assets owned by a limited liability company (“LLC”) in which we have a noncontrolling ownership interest as indicated above and include tenants who are unaffiliated third-parties.
(D) Real estate assets owned by us or an LLC in which we hold 100% ownership interests and include tenants who are subsidiaries of UHS.

 

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(E) Real estate assets owned by us or an LLC in which we hold 100% ownership interests and include tenants who are unaffiliated third-parties.
(F) The lessee on the HealthSouth Deaconess Rehabilitation Hospital (“Deaconess”) is HealthSouth/Deaconess L.L.C., a joint venture between HealthSouth Properties Corporation and Deaconess Hospital, Inc. The lease with Deaconess is scheduled to expire on May 31, 2019.
(G) Real estate assets owned by an LLC in which we have a noncontrolling ownership interest as indicated above. Tenants of this MOB include subsidiaries of UHS.
(H) This MOB was acquired during the first quarter of 2012. In connection with the third-party loan agreement on this property, we are required to maintain separate financial records for the related entities.
(I) This MOB was acquired during the first quarter of 2015.
(J) Real estate assets owned by a limited partnership (“LP”) in which we have a noncontrolling ownership interest as indicated above and include tenants who are unaffiliated third-parties.
(K) This free-standing emergency department was acquired during the third quarter of 2014 and has a 10-year initial term lease agreement with HCA Health Services of Virginia, Inc.
(L) This free-standing emergency department was acquired during the first quarter of 2015 and has a 10-year initial term lease agreement with a subsidiary of UHS.

 

Other Information

 

Included in our portfolio at December 31, 2014 are six hospital facilities with an aggregate investment of $130.4 million, (excluding the Bridgeway which was sold on December 31, 2014, as discussed below). The leases with respect to the seven hospital facilities, including the Bridgeway, comprised approximately 33% of our consolidated revenues in 2014 and approximately 36% of our consolidated revenues in each of 2013 and 2012.

 

As of January 1, 2015, the leases on our six hospital facilities have fixed terms with an average of 2.8 years remaining and include renewal options ranging from one to five, five-year terms. The remaining lease terms for each hospital facility, which vary by hospital, are included herein in Item 2. Properties.

 

We believe a facility’s earnings before interest, taxes, depreciation, amortization and lease rental expense (“EBITDAR”) and a facility’s EBITDAR divided by the sum of minimum rent plus additional rent payable to us (“Coverage Ratio”), which are non-GAAP financial measures, are helpful to us and our investors as a measure of the operating performance of a hospital facility. EBITDAR, which is used as an indicator of a facility’s estimated cash flow generated from operations (before rent expense, capital additions and debt service), is used by us in evaluating a facility’s financial viability and its ability to pay rent. For the hospital facilities owned by us at the end of each respective year (including Bridgeway which was sold on December 31, 2014, as discussed herein), the combined weighted average Coverage Ratio was approximately 8.0 (ranging from 2.7 to 18.3) during 2014, 6.3 (ranging from 2.5 to 18.5) during 2013 and 5.9 (ranging from 2.1 to 14.4) during 2012. The Coverage Ratio for individual facilities varies. See “Relationship with Universal Health Services, Inc.” below for Coverage Ratio information related to the hospital facilities leased to subsidiaries of UHS.

 

Pursuant to the terms of the leases for our hospital facilities, free-standing emergency departments and the preschool and childcare centers, each lessee, including subsidiaries of UHS, is responsible for building operations, maintenance, renovations and property insurance. We, or the LLCs in which we have invested, are responsible for the building operations, maintenance and renovations of the MOBs, however, a portion, or in some cases all, of the expenses associated with the MOBs are passed on directly to the tenants. Cash reserves have been established to fund required building maintenance and renovations at the multi-tenant MOBs. Lessees are required to maintain all risk, replacement cost and commercial property insurance policies on the leased properties and we, or the LLC in which we have invested, are also named insureds on these policies. In addition, we, UHS or the LLCs in which we have invested, maintain property insurance on all properties. For additional information on the terms of our leases, see “Relationship with Universal Health Services, Inc.”

 

See our consolidated financial statements and accompanying notes to the consolidated financial statements included in this Annual Report for our total assets, liabilities, debt, revenues, income and other operating information.

 

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Relationship with Universal Health Services, Inc. (“UHS”)

 

Leases:    We commenced operations in 1986 by purchasing properties of certain subsidiaries from UHS and immediately leasing the properties back to the respective subsidiaries. The hospital leases were entered into at the time we commenced operations and provided for initial terms of 13 to 15 years with up to six additional 5-year renewal terms. The current base rentals and lease and rental terms for each hospital leased to subsidiaries of UHS are provided below. The base rents are paid monthly and each lease also provides for additional or bonus rents which are computed and paid on a quarterly basis based upon a computation that compares current quarter revenue to a corresponding quarter in the base year. The hospital leases with subsidiaries of UHS are unconditionally guaranteed by UHS and are cross-defaulted with one another.

 

The combined revenues generated from the leases on the UHS hospital facilities accounted for approximately 36% of our total revenue for the five years ended December 31, 2014 (approximately 28% for the year ended December 31, 2014 and approximately 30% for each of the years ended December 31, 2013 and 2012). The decrease during 2014 as compared to 2013, is due primarily to the 2014 purchase of the third-party minority ownership interests in eight LLCs in which we previously held noncontrolling majority ownership interests. As a result of these transactions, we own 100% of each of these LLCs and began accounting for each on a consolidated basis effective on the date of purchase of the minority ownership interests. Including 100% of the revenues generated at the unconsolidated LLCs in which we have various non-controlling equity interests ranging from 33% to 95%, the leases on the UHS hospital facilities accounted for approximately 20% of the combined consolidated and unconsolidated revenue for the five years ended December 31, 2014 (approximately 22% for each of the years ended December 31, 2014 and 2013 and 21% for the year ended December 31, 2012). In addition, including the two free-standing emergency departments (“FEDs”) acquired by us from subsidiaries of UHS during the first quarter of 2015 (as discussed below), fifteen MOBs/FEDs, that are either wholly or jointly-owned, include tenants which are subsidiaries of UHS.

 

Pursuant to the Master Lease Document by and among us and certain subsidiaries of UHS, dated December 24, 1986 (the “Master Lease”), which governs the leases of all hospital properties with subsidiaries of UHS, UHS has the option to renew the leases at the lease terms described below by providing notice to us at least 90 days prior to the termination of the then current term. In addition, UHS has rights of first refusal to: (i) purchase the respective leased facilities during and for 180 days after the lease terms at the same price, terms and conditions of any third-party offer, or; (ii) renew the lease on the respective leased facility at the end of, and for 180 days after, the lease term at the same terms and conditions pursuant to any third-party offer. UHS also has the right to purchase the respective leased facilities at the end of the lease terms or any renewal terms at the appraised fair market value. In addition, the Master Lease, as amended during 2006, includes a change of control provision whereby UHS has the right, upon one month’s notice should a change of control of the Trust occur, to purchase any or all of the three leased hospital properties listed below at their appraised fair market value.

 

During the third quarter of 2014, a wholly-owned subsidiary of UHS provided notification to us that, upon expiration of The Bridgeway’s lease term which occurred in December, 2014, it intended to exercise its option to purchase the real property of the facility. Upon expiration of the lease, the wholly-owned subsidiary of UHS exercised its option to purchase the real property of the facility and on December 31, 2014, The Bridgeway, a 103-bed behavioral health facility located in North Little Rock, Arkansas, was sold to UHS. Pursuant to the terms of the lease, we and the wholly-owned subsidiary of UHS were both required to obtain appraisals of the property to determine its fair market value. Based upon the independent property appraisals obtained by each party, the sales price of The Bridgeway was $17.3 million. A gain on divestiture of approximately $13.0 million is included in our results of operations for the twelve-month period ended December 31, 2014. During each of the last three years, our revenues, net cash provided by operating activities and funds from operations have included approximately $1.1 million earned annually in connection with The Bridgeway’s lease.

 

During the first quarter of 2015, we purchased, from UHS, the real property of two newly-constructed and recently opened FEDs located in Weslaco and Mission, Texas. Each FED consists of approximately 13,600 square feet and will be operated by wholly-owned subsidiaries of UHS. In connection with these acquisitions,

 

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ten-year lease agreements with six, 5-year renewal terms have been executed with UHS for each FED. The first four, 5-year renewal terms (covering years 2025 through 2044) include 2% annual lease rate increases, computed on accumulative and compounded basis, and the last two, 5-year renewal terms (covering the years 2045 through 2054) will be at the then fair market value lease rates. The aggregate acquisition cost of these facilities was approximately $12.8 million, and the aggregate rental revenues earned by us at the commencement of the leases will be approximately $900,000 annually. These two leases are cross defaulted with one another.

 

The table below details the existing lease terms and renewal options for each of the UHS hospital facilities:

 

Hospital Name

   Type of Facility    Annual
Minimum
Rent
     End of Lease Term      Renewal
Term
(years)
 

McAllen Medical Center

   Acute Care    $ 5,485,000        December, 2016         15 (a) 

Wellington Regional Medical Center

   Acute Care    $ 3,030,000         December, 2016         15 (b) 

Southwest Healthcare System, Inland Valley Campus

   Acute Care    $ 2,648,000         December, 2016         15 (b) 

 

(a) UHS has three 5-year renewal options at existing lease rates (through 2031).
(b) UHS has one 5-year renewal option at existing lease rates (through 2021) and two 5-year renewal options at fair market value lease rates (2022 through 2031).

 

Management cannot predict whether the leases with subsidiaries of UHS, which have renewal options at existing lease rates or fair market value lease rates, or any of our other leases, will be renewed at the end of their lease term. If the leases are not renewed at their current rates or the fair market value lease rates, we would be required to find other operators for those facilities and/or enter into leases on terms potentially less favorable to us than the current leases. In addition, if subsidiaries of UHS exercise their options to purchase the respective leased hospital facilities upon expiration of the lease terms, our future revenues could decrease if we were unable to earn a favorable rate of return on the sale proceeds received, as compared to the rental revenue currently earned pursuant to the hospital leases.

 

Advisory Agreement:    UHS of Delaware, Inc. (the “Advisor”), a wholly-owned subsidiary of UHS, serves as Advisor to us under an Advisory Agreement (the “Advisory Agreement”) dated December 24, 1986. Pursuant to the Advisory Agreement, the Advisor is obligated to present an investment program to us, to use its best efforts to obtain investments suitable for such program (although it is not obligated to present any particular investment opportunity to us), to provide administrative services to us and to conduct our day-to-day affairs. All transactions between us and UHS must be approved by the Trustees who are unaffiliated with UHS (the “Independent Trustees”). In performing its services under the Advisory Agreement, the Advisor may utilize independent professional services, including accounting, legal, tax and other services, for which the Advisor is reimbursed directly by us. The Advisory Agreement may be terminated for any reason upon sixty days written notice by us or the Advisor.

 

The Advisory Agreement expires on December 31 of each year; however, it is renewable by us, subject to a determination by the Independent Trustees, that the Advisor’s performance has been satisfactory. Our advisory fee was 0.70% during each of 2014 and 2013, and 0.65% during 2012, of our average invested real estate assets, as derived from our consolidated balance sheet. In December of 2014, based upon a review of our advisory fee and other general and administrative expenses, as compared to an industry peer group, the Advisory Agreement was renewed for 2015 pursuant to the same terms as the Advisory Agreement in place during 2014 and 2013.

 

The average real estate assets for advisory fee calculation purposes exclude certain items from our consolidated balance sheet such as, among other things, accumulated depreciation, cash and cash equivalents, base and bonus rent receivables, deferred charges and other assets. The advisory fee is payable quarterly, subject to adjustment at year-end based upon our audited financial statements. In addition, the Advisor is entitled to an annual incentive fee equal to 20% of the amount by which cash available for distribution to shareholders for each

 

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year, as defined in the Advisory Agreement, exceeds 15% of our equity as shown on our consolidated balance sheet, determined in accordance with generally accepted accounting principles without reduction for return of capital dividends. The Advisory Agreement defines cash available for distribution to shareholders as net cash flow from operations less deductions for, among other things, amounts required to discharge our debt and liabilities and reserves for replacement and capital improvements to our properties and investments. No incentive fees were paid during 2014, 2013 or 2012 since the incentive fee requirements were not achieved. Advisory fees incurred and paid (or payable) to UHS amounted to $2.5 million during 2014, $2.4 million during 2013 and $2.1 million during 2012 and were based upon average invested real estate assets of $363 million, $338 million and $326 million during 2014, 2013 and 2012, respectively.

 

Officers and Employees:    Our officers are all employees of a wholly-owned subsidiary of UHS and although as of December 31, 2014 we had no salaried employees, our officers do typically receive annual stock-based compensation awards in the form of restricted stock. In special circumstances, if warranted and deemed appropriate by the Compensation Committee of the Board of Trustees, our officers may also receive one-time compensation awards in the form of restricted stock and/or cash bonuses.

 

Share Ownership:    As of December 31, 2014 and 2013, UHS owned 5.9% and 6.1%, respectively, of our outstanding shares of beneficial interest.

 

SEC reporting requirements of UHS:    UHS is subject to the reporting requirements of the Securities and Exchange Commission (“SEC”) and is required to file annual reports containing audited financial information and quarterly reports containing unaudited financial information. Since the leases on the hospital facilities leased to wholly-owned subsidiaries of UHS comprised approximately 28% of our consolidated revenues for the year ended December 31, 2014 and 30% of our consolidated revenues for each of the years ended December 31, 2013 and 2012, and since a subsidiary of UHS is our Advisor, you are encouraged to obtain the publicly available filings for Universal Health Services, Inc. from the SEC’s website at www.sec.gov. These filings are the sole responsibility of UHS and are not incorporated by reference herein.

 

Taxation

 

We believe we have operated in such a manner as to qualify for taxation as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, and we intend to continue to operate in such a manner. If we qualify for taxation as a REIT, we will generally not be subject to federal corporate income taxes on our net income that is currently distributed to shareholders. This treatment substantially eliminates the “double taxation”, i.e., at the corporate and shareholder levels, that usually results from investment in the stock of a corporation.

 

Please see the heading “If we fail to maintain our REIT status, we will become subject to federal income tax on our taxable income at regular corporate rates” under “Risk Factors” for more information.

 

Competition

 

We compete for the acquisition, leasing and financing of health care related facilities. Our competitors include, but are not limited to, other REITs, banks and other companies, including UHS. Some of these competitors are larger and may have a lower cost of capital than we do. These developments could result in fewer investment opportunities for us and lower spreads over the cost of our capital, which would hurt our growth.

 

In most geographical areas in which our facilities operate, there are other facilities that provide services comparable to those offered by our facilities. In addition, some competing facilities are owned by tax-supported governmental agencies or by nonprofit corporations and may be supported by endowments and charitable contributions and exempt from property, sales and income taxes. Such exemptions and support are not available to certain operators of our facilities, including UHS. In some markets, certain competing facilities may have greater financial resources, be better equipped and offer a broader range of services than those available at our

 

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facilities. Certain hospitals that are located in the areas served by our facilities are specialty hospitals that provide medical, surgical and behavioral health services that may not be provided by the operators of our hospitals. The increase in outpatient treatment and diagnostic facilities, outpatient surgical centers and freestanding ambulatory surgical centers also increases competition for us.

 

In addition, the number and quality of the physicians on a hospital’s staff are important factors in determining a hospital’s success and competitive advantage. Typically, physicians are responsible for making hospital admission decisions and for directing the course of patient treatment. The operators of our facilities also compete with other health care providers in recruiting and retaining qualified hospital management, nurses and other medical personnel. From time-to-time, the operators of our acute care hospitals may experience the effects of a shortage of skilled nursing staff nationwide, which has caused and may continue to cause an increase in salaries, wages and benefits expense in excess of the inflation rate. Our operators may experience difficulties attracting and retaining qualified physicians, nurses and medical support personnel. We anticipate that our operators, including UHS, will continue to encounter increased competition in the future that could lead to a decline in patient volumes and harm their businesses, which in turn, could harm our business.

 

A large portion of our non-hospital properties consist of MOBs which are located either close to or on the campuses of hospital facilities. These properties are either directly or indirectly affected by the factors discussed above as well as general real estate factors such as the supply and demand of office space and market rental rates. To improve our competitive position, we anticipate that we will continue investing in additional healthcare related facilities and leasing the facilities to qualified operators, perhaps including subsidiaries of UHS.

 

Regulation and Other Factors

 

During 2014, 2013 and 2012, 25%, 28% and 28%, respectively, of our revenues were earned pursuant to leases with operators of acute care services hospitals, all of which are subsidiaries of UHS. A significant portion of the revenue earned by the operators of our acute care hospitals is derived from federal and state healthcare programs, including Medicare and Medicaid (excluding managed Medicare and Medicaid programs).

 

Our hospital facilities derive a significant portion of their revenue from third-party payors, including the Medicare and Medicaid programs. Changes in these government programs in recent years have resulted in limitations on reimbursement and, in some cases, reduced levels of reimbursement for healthcare services. Payments from federal and state government programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations, requirements for utilization review, and federal and state funding restrictions, all of which could materially increase or decrease program payments, as well as affect the cost of providing service to patients and the timing of payments to facilities. Neither we nor the operators of our hospital facilities are able to predict the effect of recent and future policy changes on our respective results of operations. In addition, the uncertainty and fiscal pressures placed upon federal and state governments as a result of, among other things, the funding requirements and other provisions of the Patient Protection and Affordable Care Act, may affect the availability of taxpayer funds for Medicare and Medicaid programs. If the rates paid or the scope of services covered by government payors are reduced, there could be a material adverse effect on the business, financial position and results of operations of the operators of our hospital facilities, and in turn, ours.

 

In addition, the healthcare industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels relating to, among other things: hospital billing practices and prices for services; relationships with physicians and other referral sources; adequacy of medical care and quality of medical equipment and services; ownership of facilities; qualifications of medical and support personnel; confidentiality, maintenance, privacy and security issues associated with health-related information and patient medical records; the screening, stabilization and transfer of patients who have emergency medical conditions; certification, licensure and accreditation of our facilities; operating policies and procedures, and; construction or expansion of facilities and services.

 

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These laws and regulations are extremely complex, and, in many cases, the operators of our facilities do not have the benefit of regulatory or judicial interpretation. In the future, it is possible that different interpretations or enforcement of these laws and regulations could subject the current or past practices of our operators to allegations of impropriety or illegality or could require them to make changes in their facilities, equipment, personnel, services, capital expenditure programs and operating expenses. Although UHS and the other operators of our hospital facilities believe that their policies, procedures and practices comply with governmental regulations, no assurance can be given that they will not be subjected to additional governmental inquiries or actions, or that they would not be faced with sanctions, fines or penalties if so subjected. Even if they were to ultimately prevail, a significant governmental inquiry or action under one of the above laws, regulations or rules could have a material adverse effect upon them, and in turn, us.

 

Each of our hospital facilities is deemed certified, meaning that they are accredited, properly licensed under the relevant state laws and regulations and certified under the Medicare program. The effect of maintaining certified facilities is to allow such facilities to participate in the Medicare and Medicaid programs. The operators of our hospital facilities believe that the facilities are in material compliance with applicable federal, state, local and other relevant regulations and standards. However, should any of our hospital facilities lose their deemed certified status and thereby lose certification under the Medicare or Medicaid programs, such facilities would be unable to receive reimbursement from either of those programs and their business, and in turn, ours, could be materially adversely affected.

 

The various factors and government regulation related to the healthcare industry, such as those outlined above, affects us because:

 

(i) The financial ability of lessees to make rent payments to us may be affected by governmental regulations such as licensure, certification for participation in government programs, and government reimbursement, and;

 

(ii) Our bonus rents on the three acute care hospitals operated by subsidiaries of UHS are based on our lessees’ net revenues which in turn are affected by the amount of reimbursement such lessees receive from the government.

 

A significant portion of the revenue earned by the operators of our acute care hospitals is derived from federal and state healthcare programs, including Medicare and Medicaid. Under the statutory framework of the Medicare and Medicaid programs, many of the general acute care operations are subject to administrative rulings, interpretations and discretion that may affect payments made under either or both of such programs as well as by other third party payors. The federal government makes payments to participating hospitals under its Medicare program based on various formulas. For inpatient services, the operators of our acute care hospitals are subject to an inpatient prospective payment system (“IPPS”). Under IPPS, hospitals are paid a predetermined fixed payment amount for each hospital discharge. The fixed payment amount is based upon each patient’s Medicare severity diagnosis related group (“MS-DRG”). Every MS-DRG is assigned a payment rate based upon the estimated intensity of hospital resources necessary to treat the average patient with that particular diagnosis. These rates are based upon historical national average costs and do not consider the actual costs incurred by a hospital in providing care. The MS-DRG rates are adjusted annually based on geographic region and are weighted based upon a statistically normal distribution of severity.

 

For outpatient services, acute care hospitals are paid under an outpatient prospective payment system (“PPS”) according to ambulatory procedure codes. The outpatient PPS rate is a geographic adjusted national payment amount that includes the Medicare payment and the beneficiary co-payment. Special payments under the outpatient PPS may be made for certain new technology items and services through transitional pass-through payments and special reimbursement rates.

 

Three of our acute care hospital facilities operated by subsidiaries of UHS and two sub-acute care hospital facilities operated by an unaffiliated third-party are located in Texas, Florida, California and Illinois. The

 

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majority of these states have reported significant budget deficits that have resulted in reductions of Medicaid funding during the last few years and which could adversely affect future levels of Medicaid reimbursement received by certain operators of our facilities, including the operators of our hospital facilities. We can provide no assurance that reductions to Medicaid revenues earned by operators of certain of our facilities, particularly our hospital operators in the above-mentioned states, will not have a material adverse effect on the future operating results of those operators which, in turn, could have a material adverse effect on us.

 

Executive Officers of the Registrant

 

Name

  

Age

  

Position

Alan B. Miller

   77   

Chairman of the Board, Chief Executive Officer and President

Charles F. Boyle

   55   

Vice President and Chief Financial Officer

Cheryl K. Ramagano

   52   

Vice President, Treasurer and Secretary

Timothy J. Fowler

   59   

Vice President, Acquisition and Development

 

Mr. Alan B. Miller has been our Chairman of the Board and Chief Executive Officer since our inception in 1986 and was appointed President in February, 2003. He had previously served as our President until 1990. Mr. Miller has been Chairman of the Board and Chief Executive Officer of UHS since its inception in 1978. He previously held the title of President of UHS as well, until 2009 when Marc D. Miller was elected as President of UHS. He is the father of Marc D. Miller, who was elected to our Board of Trustees in December, 2008 and also serves as President and a member of the Board of Directors of UHS.

 

Mr. Charles F. Boyle was appointed Chief Financial Officer in February, 2003 and had served as our Vice President and Controller since 1991. Mr. Boyle has held various positions at UHS since 1983 and currently serves as its Vice President and Controller. He was appointed Controller of UHS in 2003 and had served as its Assistant Vice President-Corporate Accounting since 1994.

 

Ms. Cheryl K. Ramagano was appointed Secretary in February, 2003 and has served as our Vice President and Treasurer since 1992. Ms. Ramagano has held various positions at UHS since 1983 and currently serves as its Vice President and Treasurer. She was appointed Treasurer of UHS in 2003 and had served as its Assistant Treasurer since 1994.

 

Mr. Timothy J. Fowler was elected as our Vice President of Acquisition and Development upon the commencement of his employment with UHS in 1993.

 

ITEM 1A. Risk Factors

 

We are subject to numerous known and unknown risks, many of which are described below and elsewhere in this Annual Report. Any of the events described below could have a material adverse effect on our business, financial condition and results of operations. Additional risks and uncertainties that we are not aware of, or that we currently deem to be immaterial, could also impact our business and results of operations.

 

The revenues and results of operations of the tenants of our hospital facilities, including UHS, and our medical office buildings, are significantly affected by payments received from the government and other third party payors.

 

The operators of our hospital facilities and tenants of our medical office buildings derive a significant portion of their revenue from third party payors, including the Medicare and Medicaid programs. Changes in these government programs in recent years have resulted in limitations on reimbursement and, in some cases, reduced levels of reimbursement for health care services. Payments from federal and state government programs are subject to statutory and regulatory changes, administrative rulings, interpretations and determinations, requirements for utilization review, and federal and state funding restrictions, all of which could materially

 

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increase or decrease program payments, as well as affect the cost of providing service to patients and the timing of payments to facilities. Our tenants are unable to predict the effect of recent and future policy changes on their operations.

 

Three of our acute care hospital facilities operated by subsidiaries of UHS and two sub-acute care hospital facilities operated by an unaffiliated third-party are located in Texas, Florida, California and Illinois. The majority of these states have reported significant budget deficits that have resulted in reductions of Medicaid funding during the last few years and which could adversely affect future levels of Medicaid reimbursement received by certain operators of our facilities, including the operators of our hospital facilities. We can provide no assurance that reductions to Medicaid revenues earned by operators of certain of our facilities, particularly our hospital operators in the above-mentioned states, will not have a material adverse effect on the future operating results of those operators which, in turn, could have a material adverse effect on us. In addition, the uncertainty and fiscal pressures placed upon federal and state governments as a result of, among other things, the funding requirements and other provisions of the Patient Protection and Affordable Care Act, may affect the availability of taxpayer funds for Medicare and Medicaid programs. If the rates paid or the scope of services covered by government payors are reduced, there could be a material adverse effect on the business, financial position and results of operations of the operators of our hospital facilities, and in turn, ours.

 

In addition to changes in government reimbursement programs, the ability of our hospital operators to negotiate favorable contracts with private payors, including managed care providers, significantly affects the revenues and operating results of those facilities. Private payors, including managed care providers, increasingly are demanding that hospitals accept lower rates of payment. Our hospital operators expect continued third party efforts to aggressively manage reimbursement levels and cost controls. Reductions in reimbursement amounts received from third party payors could have a material adverse effect on the financial position and results of operations of our hospital operators.

 

Reductions or changes in Medicare funding could have a material adverse effect on the future operating results of the operators of our facilities, including UHS, which could, in turn, materially reduce our revenues and net income.

 

On January 3, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (the “2012 Act”). The 2012 Act postponed for two months sequestration cuts mandated under the Budget Control Act of 2011. The postponed sequestration cuts include a 2% annual reduction over ten years in Medicare spending to providers. Medicaid is exempt from sequestration. In order to offset the cost of the legislation, the 2012 Act reduces payments to other providers totaling almost $26 billion over ten years. Approximately half of those funds will come from reductions in Medicare reimbursement to hospitals. Although the Bipartisan Budget Act of 2013 has reduced certain sequestration-related budgetary cuts, spending reductions related to the Medicare program remain in place. On December 26, 2013, President Obama signed into law H.J. Res. 59, the Bipartisan Budget Act of 2013, which includes the Pathway for SGR Reform Act of 2013 (“the Act”). In addition, on February 15, 2014, Public Law 113-082 was enacted. The Act and subsequent federal legislation achieves new savings by extending sequestration for mandatory programs – including Medicare – for another three years, through 2024.

 

The 2012 Act includes a document and coding (“DCI”) adjustment and a reduction in Medicaid disproportionate share hospital (“DSH”) payments. Expected to save $10.5 billion over 10 years, the DCI adjustment decreases projected Medicare hospital payments for inpatient and overnight care through a downward adjustment in annual base payment increases. These reductions are meant to recoup what Medicare authorities consider to be “overpayments” to hospitals that occurred as a result of the transition to Medicare Severity Diagnosis Related Groups. The reduction in Medicaid DSH payments is expected to save $4.2 billion over 10 years. This provision extends the changes regarding DSH payments established by the Legislation and determines future allotments off of the rebased level. We cannot predict the effect this enactment will have on operators (including UHS), and, thus, our business.

 

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The uncertainties of health care reform could materially affect the business and future results of operations of the operators of our facilities, including UHS, which could, in turn, materially reduce our revenues and net income.

 

In March, 2010, the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act were enacted into law and created significant changes to health insurance coverage for U.S. citizens as well as material revisions to the federal Medicare and state Medicaid programs. The two combined primary goals of these acts are to provide for increased access to coverage for healthcare and to reduce healthcare-related expenses. Medicare, Medicaid and other health care industry changes are scheduled to be implemented at various times during this decade. We cannot predict the effect, if any, these enactments will have on operators (including UHS) and, thus, our business.

 

There have been several attempts in Congress to repeal or modify various provisions of the Patient Protection and Affordable Care Act (the “PPACA”). We cannot predict whether or not any of these proposed changes to the PPACA will become law and therefore can provide no assurance that changes to the PPACA, as currently implemented, will not have a material adverse effect on the future operating results of the tenants/operators of our properties and, thus, our business.

 

In addition, a case currently pending before The Supreme Court of the United States, King vs. Burwell, challenges the federal government’s ability to subsidize premiums paid by certain eligible individuals that obtain health insurance policies through federally facilitated exchanges. A number of our properties are located in states that utilize federally facilitated exchanges. The Supreme Court of the United States’ decision in this case could result in an increased number of uninsured patients in the states that utilize federally facilitated exchanges which would have an adverse impact on the future operating results of the tenants/operators of our facilities located in these states and, thus, our business.

 

Increased competition in the health care industry has resulted in lower revenues and higher costs for our operators, including UHS, and may affect our revenues, property values and lease renewal terms.

 

The health care industry is highly competitive and competition among hospitals and other health care providers for patients and physicians has intensified in recent years. In most geographical areas in which our facilities are operated, there are other facilities that provide services comparable to those offered by our facilities. In addition, some competing facilities are owned by tax-supported governmental agencies or by nonprofit corporations and may be supported by endowments and charitable contributions and exempt from property, sales and income taxes. Such exemptions and support are not available to certain operators of our facilities, including UHS.

 

In some markets, certain competing facilities may have greater financial resources, be better equipped and offer a broader range of services than those available at our facilities. Certain hospitals that are located in the areas served by our facilities are specialty hospitals that provide medical, surgical and behavioral health services that may not be provided by the operators of our hospitals. The increase in outpatient treatment and diagnostic facilities, outpatient surgical centers and freestanding ambulatory surgical centers also increases competition for our operators.

 

In addition, the operators of our facilities face competition from other health care providers, including physician owned facilities and other competing facilities, including certain facilities operated by UHS but the real property of which is not owned by us. Such competition is experienced in markets including, but not limited to, McAllen, Texas, the site of our McAllen Medical Center, a 430-bed acute care hospital, and Riverside County, California, the site of our Southwest Healthcare System-Inland Valley Campus, a 132-bed acute care hospital.

 

In addition, the number and quality of the physicians on a hospital’s staff are important factors in determining a hospital’s competitive advantage. Typically, physicians are responsible for making hospital

 

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admission decisions and for directing the course of patient treatment. Since the operators of our facilities also compete with other health care providers, they may experience difficulties in recruiting and retaining qualified hospital management, nurses and other medical personnel.

 

We anticipate that our operators, including UHS, will continue to encounter increased competition in the future that could lead to a decline in patient volumes and harm their businesses, which in turn, could harm our business.

 

Operators that fail to comply with governmental reimbursement programs such as Medicare or Medicaid, licensing and certification requirements, fraud and abuse regulations or new legislative developments may be unable to meet their obligations to us.

 

Our operators, including UHS and its subsidiaries, are subject to numerous federal, state and local laws and regulations that are subject to frequent and substantial changes (sometimes applied retroactively) resulting from legislation, adoption of rules and regulations, and administrative and judicial interpretations of existing law. The ultimate timing or effect of these changes cannot be predicted. Government regulation may have a dramatic effect on our operators’ costs of doing business and the amount of reimbursement received by both government and other third-party payors. The failure of any of our operators to comply with these laws, requirements and regulations could adversely affect their ability to meet their obligations to us. These regulations include, among other items: hospital billing practices and prices for service; relationships with physicians and other referral sources; adequacy of medical care; quality of medical equipment and services; qualifications of medical and support personnel; the implementation of, and continued compliance with, electronic health records’ regulations; confidentiality, maintenance and security issues associated with health-related information and patient medical records; the screening, stabilization and transfer of patients who have emergency medical conditions; certification, licensure and accreditation of our facilities; operating policies and procedures, and; construction or expansion of facilities and services.

 

If our operators fail to comply with applicable laws and regulations, they could be subjected to liabilities, including criminal penalties, civil penalties (including the loss of their licenses to operate one or more facilities), and exclusion of one or more facilities from participation in the Medicare, Medicaid and other federal and state health care programs. The imposition of such penalties could jeopardize that operator’s ability to make lease or mortgage payments to us or to continue operating its facility. In addition, our bonus rents are based on net revenues of the UHS hospital facilities, which in turn are affected by the amount of reimbursement that such lessees receive from the government.

 

Although UHS and the other operators of our acute care facilities believe that their policies, procedures and practices comply with governmental regulations, no assurance can be given that they will not be subjected to governmental inquiries or actions, or that they would not be faced with sanctions, fines or penalties if so subjected. Because many of these laws and regulations are relatively new, in many cases, our operators don’t have the benefit of regulatory or judicial interpretation. In the future, it is possible that different interpretations or enforcement of these laws and regulations could subject their current or past practices to allegations of impropriety or illegality or could require them to make changes in the facilities, equipment, personnel, services, capital expenditure programs and operating expenses. Even if they were to ultimately prevail, a significant governmental inquiry or action under one of the above laws, regulations or rules could have a material adverse effect upon them, and in turn, us.

 

A worsening of the economic and employment conditions in the United States could materially affect our business and future results of operations of the operators of our facilities which could, in turn, materially reduce our revenues and net income.

 

Our future results of operations could be unfavorably impacted by deterioration in general economic conditions which could result in increases in the number of people unemployed and/or uninsured. Our operators’ patient volumes, revenues and financial results depend significantly on the universe of patients with health

 

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insurance, which to a large extent is dependent on the employment status of individuals in certain markets. A worsening of economic conditions may result in a higher unemployment rate which will likely increase the number of individuals without health insurance. As a result, the operators of our facilities may experience a decrease in patient volumes. Should that occur, it may result in decreased occupancy rates at our medical office buildings as well as a reduction in the revenues earned by the operators of our hospital facilities which would unfavorably impact our future bonus rentals (on the UHS hospital facilities) and may potentially have a negative impact on the future lease renewal terms and the underlying value of the hospital properties.

 

The deterioration of credit and capital markets may adversely affect our access to sources of funding and we cannot be certain of the availability and terms of capital to fund the growth of our business when needed.

 

To retain our status as a REIT, we are required to distribute 90% of our taxable income to shareholders and, therefore, we generally cannot use income from operations to fund our growth. Accordingly, our growth strategy depends, in part, upon our ability to raise additional capital at reasonable costs to fund new investments. We believe we will be able to raise additional debt and equity capital at reasonable costs to refinance our debts (including third-party debt held by various LLCs in which we own non-controlling equity interests) at or prior to their maturities and to invest at yields which exceed our cost of capital. We can provide no assurance that financing will be available to us on satisfactory terms when needed, which could harm our business. Given these uncertainties, our growth strategy is not assured and may fail.

 

To fund all or a portion of our future financing needs, we rely on borrowings from various sources including fixed rate, long-term debt as well as borrowings pursuant to our revolving credit agreement. If any of the lenders were unable to fulfill their future commitments, our liquidity could be impacted, which could have a material unfavorable impact on our results of operations and financial condition.

 

In addition, the degree to which we are, or in the future may become, leveraged, our ability to obtain financing could be adversely impacted and could make us more vulnerable to competitive pressures. Our ability to meet existing and future debt obligations depends upon our future performance and our ability to secure additional financing on satisfactory terms, each of which is subject to financial, business and other factors that are beyond our control. Any failure by us to meet our financial obligations would harm our business.

 

In the event we need to access the capital markets or other sources of financing, there can be no assurance that we will be able to obtain financing on acceptable terms or within an acceptable time. Our inability to obtain financing on terms acceptable to us could have a material unfavorable impact on our results of operations, financial condition and liquidity.

 

A substantial portion of our revenues are dependent upon one operator. If UHS experiences financial difficulties, or otherwise fails to make payments to us, or elects not to renew the leases on our three acute care hospitals, our revenues could be materially reduced.

 

For the year ended December 31, 2014, UHS accounted for 35% of our consolidated revenues. In addition, as of December 31, 2014, subsidiaries of UHS leased three of the six hospital facilities owned by us with terms expiring in 2016 (The Bridgeway was sold on December 31, 2014). We cannot assure you that UHS will renew the leases at existing lease rates or fair market value lease rates, or continue to satisfy its obligations to us. In addition, if subsidiaries of UHS exercise their options to purchase the respective leased hospital facilities upon expiration of the lease terms, our future revenues could decrease if we were unable to earn a favorable rate of return on the sale proceeds received, as compared to the rental revenue currently earned pursuant to the hospital leases. The failure or inability of UHS to satisfy its obligations to us, or should UHS elect not to renew the leases on our three acute care hospitals, our revenues and net income could be materially reduced, which could in turn reduce the amount of dividends we pay and cause our stock price to decline.

 

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Our relationship with UHS may create conflicts of interest.

 

In addition to being dependent upon UHS for a substantial portion of our revenues and leases, since 1986, UHS of Delaware, Inc. (the “Advisor”), a wholly-owned subsidiary of UHS, has served as our Advisor. Pursuant to our Advisory Agreement, the Advisor is obligated to present an investment program to us, to use its best efforts to obtain investments suitable for such program (although it is not obligated to present any particular investment opportunity to us), to provide administrative services to us and to conduct our day-to-day affairs. Further, all of our officers are employees of the Advisor. As of December 31, 2014 we had no salaried employees although our officers do typically receive annual stock-based compensation awards in the form of restricted stock. In special circumstances, if warranted and deemed appropriate by the Compensation Committee of the Board of Trustees, our officers may also receive one-time compensation awards in the form of restricted stock and/or cash bonuses. We believe that the quality and depth of the management and advisory services provided to us by our Advisor and UHS could not be replicated by contracting with unrelated third parties or by being self-advised without considerable cost increases. We believe that these relationships have been beneficial to us in the past, but we cannot guarantee that they will not become detrimental to us in the future.

 

All transactions with UHS must be approved by a majority of our Independent Trustees. We believe that our current leases and business dealings with UHS have been entered into on commercially reasonable terms. However, because of our historical and continuing relationship with UHS and its subsidiaries, in the future, our business dealings may not be on the same or as favorable terms as we might achieve with a third party with whom we do not have such a relationship. Disputes may arise between us and UHS that we are unable to resolve or the resolution of these disputes may not be as favorable to us as a resolution we might achieve with a third party.

 

We hold significant, non-controlling equity ownership interests in various LLCs.

 

For the year ended December 31, 2014, 22% of our consolidated and unconsolidated revenues were generated by LLCs in which we hold, or held, a majority, non-controlling equity ownership interest. As of December 31, 2014, we hold non-controlling equity ownership interests, ranging from 33% to 95%, in five LLCs/LPs.

 

Our level of investment and lack of control exposes us to potential losses of our investments and revenues. Although our ownership arrangements have been beneficial to us in the past, we cannot guarantee that they will continue to be beneficial in the future.

 

Pursuant to the operating and/or partnership agreements of most of the five LLCs in which we continue to hold non-controlling majority ownership interests, the third-party member and the Trust, at any time, have the right to make an offer (“Offering Member”) to the other member(s) (“Non-Offering Member”) in which it either agrees to: (i) sell the entire ownership interest of the Offering Member to the Non-Offering Member (“Offer to Sell”) at a price as determined by the Offering Member (“Transfer Price”), or; (ii) purchase the entire ownership interest of the Non-Offering Member (“Offer to Purchase”) at the equivalent proportionate Transfer Price. The Non-Offering Member has 60 to 90 days to either: (i) purchase the entire ownership interest of the Offering Member at the Transfer Price, or; (ii) sell its entire ownership interest to the Offering Member at the equivalent proportionate Transfer Price. The closing of the transfer must occur within 60 to 90 days of the acceptance by the Non-Offering Member.

 

In addition to the above-mentioned rights of the third-party members, from time to time, we have had discussions with third-party members about purchasing or selling the interests to each other or a third party. If we were to sell our interests, we may not be able to redeploy the proceeds into assets at the same or greater return as we currently receive. During any such time that we were not able to do so, our ability to increase or maintain our dividend at current levels could be adversely affected which could cause our stock price to decline.

 

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The bankruptcy, default, insolvency or financial deterioration of our tenants could significantly delay our ability to collect unpaid rents or require us to find new operators.

 

Our financial position and our ability to make distributions to our shareholders may be adversely affected by financial difficulties experienced by any of our major tenants, including bankruptcy, insolvency or a general downturn in the business. We are exposed to the risk that our operators may not be able to meet their obligations, which may result in their bankruptcy or insolvency. Although our leases and loans provide us the right to terminate an investment, evict an operator, demand immediate repayment and other remedies, the bankruptcy laws afford certain rights to a party that has filed for bankruptcy or reorganization. An operator in bankruptcy may be able to restrict our ability to collect unpaid rents or interest during the bankruptcy proceeding.

 

Required regulatory approvals can delay or prohibit transfers of our healthcare facilities.

 

Transfers of healthcare facilities to successor tenants or operators may be subject to regulatory approvals or ratifications, including, but not limited to, change of ownership approvals under certificate of need laws and Medicare and Medicaid provider arrangements that are not required for transfers of other types of commercial operations and other types of real estate. The replacement of any tenant or operator could be delayed by the regulatory approval process of any federal, state or local government agency necessary for the transfer of the facility or the replacement of the operator licensed to manage the facility. If we are unable to find a suitable replacement tenant or operator upon favorable terms, or at all, we may take possession of a facility, which might expose us to successor liability or require us to indemnify subsequent operators to whom we might transfer the operating rights and licenses, all of which may materially adversely affect our business, results of operations, and financial condition.

 

Real estate ownership creates risks and liabilities that may result in unanticipated losses or expenses.

 

Our business is subject to risks associated with real estate acquisitions and ownership, including:

 

   

general liability, property and casualty losses, some of which may be uninsured;

 

   

the illiquid nature of real estate and the real estate market that impairs our ability to purchase or sell our assets rapidly to respond to changing economic conditions;

 

   

real estate market factors, such as the supply and demand of office space and market rental rates, changes in interest rates as well as an increase in the development of medical office condominiums in certain markets;

 

   

costs that may be incurred relating to maintenance and repair, and the need to make expenditures due to changes in governmental regulations, including the Americans with Disabilities Act;

 

   

environmental hazards at our properties for which we may be liable, including those created by prior owners or occupants, existing tenants, mortgagors or other persons, and;

 

   

defaults and bankruptcies by our tenants.

 

In addition to the foregoing risks, we cannot predict whether the leases on our properties, including the leases on the properties leased to subsidiaries of UHS, which have options to purchase the respective leased facilities at the end of the lease or renewal terms at the appraised fair market value, will be renewed at their current rates at the end of the lease terms in 2016. If the leases are not renewed, we may be required to find other operators for these facilities and/or enter into leases with less favorable terms. The exercise of purchase options for our facilities may result in a less favorable rate of return for us than the rental revenue currently earned on such facilities. Further, the purchase options and rights of first refusal granted to the respective lessees to purchase or lease the respective leased facilities, after the expiration of the lease term, may adversely affect our ability to sell or lease a facility, and may present a potential conflict of interest between us and UHS since the price and terms offered by a third-party are likely to be dependent, in part, upon the financial performance of the facility during the final years of the lease term.

 

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Significant potential liabilities and rising insurance costs and availability may have an adverse effect on the operations of our operators, which may negatively impact their ability to meet their obligations to us.

 

As is typical in the healthcare industry, in the ordinary course of business, our operators, including UHS, are subject to medical malpractice lawsuits, product liability lawsuits, class action lawsuits and other legal actions. Some of these actions may involve large claims, as well as significant defense costs. If their ultimate liability for professional and general liability claims could change materially from current estimates, if such policy limitations should be partially or fully exhausted in the future, or payments of claims exceed estimates or are not covered by insurance, it could have a material adverse effect on the operations of our operators and, in turn, us.

 

Property insurance rates, particularly for earthquake insurance in California, have also continued to increase. We own two MOBs in California that could not obtain earthquake insurance at rates which are economically beneficial in relation to the risks covered. Our tenants and operators, including UHS, may be unable to fulfill their insurance, indemnification and other obligations to us under their leases and mortgages and thereby potentially expose us to those risks. In addition, our tenants and operators may be unable to pay their lease or mortgage payments, which could potentially decrease our revenues and increase our collection and litigation costs. Moreover, to the extent we are required to foreclose on the affected facilities, our revenues from those facilities could be reduced or eliminated for an extended period of time. In addition, we may in some circumstances be named as a defendant in litigation involving the actions of our operators. Although we have no involvement in the activities of our operators and our standard leases generally require our operators to carry insurance to cover us in certain cases, a significant judgment against us in such litigation could exceed our and our operators’ insurance coverage, which would require us to make payments to cover the judgment.

 

If we fail to maintain our REIT status, we will become subject to federal income tax on our taxable income at regular corporate rates.

 

In order to qualify as a REIT, we must comply with certain highly technical and complex Internal Revenue Code provisions. Although we believe we have been qualified as a REIT since our inception, there can be no assurance that we have been so qualified or will remain qualified in the future. Failure to qualify as a REIT may subject us to income tax liabilities, including federal income tax at regular corporate rates. The additional income tax incurred may significantly reduce the cash flow available for distribution to shareholders and for debt service. In addition, if disqualified, we might be barred from qualification as a REIT for four years following disqualification. Also, if disqualified, we will not be allowed a deduction for distributions to stockholders in computing our taxable income and we could be subject to increased state and local income taxes.

 

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

 

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, property and transfer taxes. Any of these taxes would decrease cash available for the payment of our debt obligations.

 

Dividends paid by REITs generally do not qualify for reduced tax rates.

 

In general, dividends (qualified) paid by a U.S. corporation to individual U.S. shareholders are subject to Federal income tax at a maximum rate of 20% (subject to certain additional taxes for certain taxpayers). In contrast, since we are a REIT, our distributions to individual U.S. shareholders are not eligible for the reduced rates which apply to distributions from regular corporations, and thus may be subject to Federal income tax at a rate as high as 39.6% (subject to certain additional taxes for certain taxpayers).

 

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Should we be unable to comply with the strict income distribution requirements applicable to REITs utilizing only cash generated by operating activities, we would be required to generate cash from other sources which could adversely affect our financial condition.

 

To obtain the favorable tax treatment associated with qualifying as a REIT, in general, we are required each year to distribute to our shareholders at least 90% of our net taxable income. In addition, we are subject to a tax on any undistributed portion of our income at regular corporate rates and might also be subject to a 4% excise tax on this undistributed income. To meet the distribution requirements necessary to achieve the tax benefits associated with qualifying as a REIT, we could be required to: (i) seek borrowed funds even if conditions are not favorable for borrowing; (ii) issue equity which could have a dilutive effect on the future dividends and share value of our existing shareholders, and/or; (iii) divest assets that we might have otherwise decided to retain. Securing funds through these other non-operating means could adversely affect our financial condition and future results of operations.

 

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.

 

To qualify as a REIT for federal income tax purposes, we continually must satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock. We may be unable to pursue investments that would be otherwise advantageous to us in order to satisfy the source-of-income, asset-diversification or distribution requirements for qualifying as a REIT. Thus, compliance with the REIT requirements may hinder our ability to make certain attractive investments.

 

The market value of our common stock could be substantially affected by various factors.

 

Many factors, certain of which are outside of our control, could have an adverse effect on the share price of our common stock. These factors include certain of the risks discussed herein, our financial condition, performance and prospects, the market for similar securities issued by REITs, demographic changes, operating results of our operators and other hospital companies, changes in our financial estimates or recommendations of securities analysts, speculation in the press or investment community, the possible effects of war, terrorist and other hostilities, adverse weather conditions, the level of seasonal illnesses, changes in general conditions in the economy, financial markets or overall interest rate environment, or other developments affecting the health care industry.

 

Ownership limitations and anti-takeover provisions in our declaration of trust and bylaws and under Maryland law and in our leases with UHS may delay, defer or prevent a change in control or other transactions that could provide shareholders with a take-over premium. We are subject to significant anti-takeover provisions.

 

In order to protect us against the risk of losing our REIT status for federal income tax purposes, our declaration of trust permits our Trustees to redeem shares acquired or held in excess of 9.8% of the issued and outstanding shares of our voting stock and, which in the opinion of the Trustees, would jeopardize our REIT status. In addition, any acquisition of our common or preferred shares that would result in our disqualification as a REIT is null and void. The right of redemption may have the effect of delaying, deferring or preventing a change in control of our company and could adversely affect our shareholders’ ability to realize a premium over the market price for the shares of our common stock.

 

Our declaration of trust authorizes our Board of Trustees to issue additional shares of common and preferred stock and to establish the preferences, rights and other terms of any series of preferred stock that we issue. Although our Board of Trustees has no intention to do so at the present time, it could establish a series of preferred stock that could delay, defer or prevent a transaction or a change in control that might involve the payment of a premium over the market price for our common stock or otherwise be in the best interests of our shareholders.

 

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The Master Lease Documents by and among us and certain subsidiaries of UHS, which governs the three acute care hospital properties and the freestanding emergency departments leased to subsidiaries of UHS, includes a change of control provision. The change of control provision grants UHS the right, upon one month’s notice should a change of control of the Trust occur, to purchase any or all of the leased hospital properties at their appraised fair market values. The exercise of this purchase option may result in a less favorable rate of return earned on the sales proceeds received than the rental revenue currently earned on such facilities.

 

These provisions could discourage unsolicited acquisition proposals or make it more difficult for a third-party to gain control of us, which could adversely affect the market price of our securities and prevent shareholders from receiving a take-over premium.

 

We depend heavily on key management personnel and the departure of one or more of our key executives or a significant portion of our operators’ local hospital management personnel could harm our business.

 

The expertise and efforts of our senior executives and key members of our operators’ local hospital management personnel are critical to the success of our business. The loss of the services of one or more of our senior executives or of a significant portion of our operators’ local hospital management personnel could significantly undermine our management expertise and our operators’ ability to provide efficient, quality health care services at our facilities, which could harm their business, and in turn, harm our business.

 

Increasing investor interest in our sector and consolidation at the operator or REIT level could increase competition and reduce our profitability.

 

Our business is highly competitive and we expect that it may become more competitive in the future. We compete for the acquisition, leasing and financing of health care related facilities. Our competitors include, but are not limited to, other REITs, banks and other companies, including UHS, some of which are larger and may have a lower cost of capital than we do. These developments could result in fewer investment opportunities for us and lower spreads over our cost of our capital, which would hurt our growth. Increased competition makes it more challenging for us to identify and successfully capitalize on opportunities that meet our business goals and could improve the bargaining power of property owners seeking to sell, thereby impeding our investment, acquisition and development activities. If we cannot capitalize on our development pipeline, identify and purchase a sufficient quantity of healthcare facilities at favorable prices or if we are unable to finance acquisitions on commercially favorable terms, our business, results of operations and financial condition may be materially adversely affected.

 

We may be required to incur substantial renovation costs to make certain of our healthcare properties suitable for other operators and tenants.

 

Healthcare facilities are typically highly customized and may not be easily adapted to non-healthcare-related uses. The improvements generally required to conform a property to healthcare use, such as upgrading electrical, gas and plumbing infrastructure, are costly and at times tenant-specific. A new or replacement operator or tenant may require different features in a property, depending on that operator’s or tenant’s particular operations. If a current operator or tenant is unable to pay rent and vacates a property, we may incur substantial expenditures to modify a property before we are able to secure another operator or tenant. Also, if the property needs to be renovated to accommodate multiple operators or tenants, we may incur substantial expenditures before we are able to re-lease the space. These expenditures or renovations may materially adversely affect our business, results of operations and financial condition.

 

We are subject to significant corporate regulation as a public company and failure to comply with all applicable regulations could subject us to liability or negatively affect our stock price.

 

As a publicly traded company, we are subject to a significant body of regulation, including the Sarbanes-Oxley Act of 2002. While we have developed and instituted a corporate compliance program based on what we believe are the current best practices in corporate governance and continue to update this program in response to

 

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newly implemented or changing regulatory requirements, we cannot provide assurance that we are or will be in compliance with all potentially applicable corporate regulations. For example, we cannot provide assurance that in the future our management will not find a material weakness in connection with its annual review of our internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act. We also cannot provide assurance that we could correct any such weakness to allow our management to assess the effectiveness of our internal control over financial reporting as of the end of our fiscal year in time to enable our independent registered public accounting firm to state that we have maintained effective internal control over financial reporting as of the end of our fiscal year. If we fail to comply with any of these regulations, we could be subject to a range of regulatory actions, fines or other sanctions or litigation. If we must disclose any material weakness in our internal control over financial reporting, our stock price could decline.

 

Different interpretations of accounting principles could have a material adverse effect on our results of operations or financial condition.

 

Generally accepted accounting principles are complex, continually evolving and may be subject to varied interpretation by us, our independent registered public accounting firm and the SEC. Such varied interpretations could result from differing views related to specific facts and circumstances. Differences in interpretation of generally accepted accounting principles could have a material adverse effect on our financial position or results of operations.

 

Item 1B. Unresolved Staff Comments

 

None.

 

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ITEM 2. Properties

 

The following table shows our investments in hospital facilities leased to UHS and other non-related parties and also provides information related to various properties in which we have significant investments, some of which are accounted for by the equity method. The capacity in terms of beds (for the hospital facilities) and the five-year occupancy levels are based on information provided by the lessees.

 

    Type of
facility
  Number
of
available
beds @
12/31/14
          Lease Term     % of RSF
under
lease with
guaranteed
escalators
    Range of
guaranteed
escalation
 

Hospital Facility Name and
Location

      Average Occupancy(1)     Minimum
rent(5)
    End of
initial
or
renewed
term
    Renewal
term
(years)
     
      2014     2013     2012     2011     2010            

Southwest Healthcare System:

Inland Valley Campus(2)(7)

Wildomar, California

  Acute Care     132        59     58     62     70     78   $ 2,648,000        2016        15        0      

McAllen Medical Center(3)(7)

McAllen, Texas

  Acute Care     430        44     43     43     45     47     5,485,000        2016        15        0      

Wellington Regional Medical Center(7)

West Palm Beach, Florida

  Acute Care     153        59     58     69     73     70     3,030,000        2016        15        0      

HealthSouth Deaconess Rehab. Hospital(8)

Evansville, Indiana

  Rehabilitation     85        80     79     79     75     71     714,000        2019        5        0      

Vibra Hospital of Corpus Christi

Corpus Christi, Texas

  Sub-Acute Care     74        58     58     53     54     64     742,000        2019        25        100     3

Kindred Hospital Chicago Central(9)

Chicago, Illinois

  Sub-Acute Care     84        54     51     51     46     40     1,474,000        2016        5        0      

 

    Type
of
facility
                                  Lease Term              

Facility Name and Location

    Average Occupancy(1)     Minimum
rent(5)
    End of
initial
or
renewed
term
    Renewal
term
(years)
    % of RSF
under
lease with
guaranteed
escalators
    Range of
guaranteed
escalation
 
    2014     2013     2012     2011     2010            

Spring Valley MOB I(4)
Las Vegas, Nevada

    MOB        60     64     68     75     93   $ 544,000        2015-2018        Various        69     2 %-3% 

Spring Valley MOB II(4)
Las Vegas, Nevada

    MOB        77     76     76     67     53     1,087,000        2016-2020        Various        25     1 %-3% 

Summerlin Hospital MOB I(4)
Las Vegas, Nevada

    MOB        66     77     81     90     91     778,000        2015-2020        Various        43     2 %-3% 

Summerlin Hospital MOB II(4)
Las Vegas, Nevada

    MOB        78     74     82     83     97     1,263,000        2015-2021        Various        52     2 %-3% 

Summerlin Hospital MOB III(4)
Las Vegas, Nevada

    MOB        90     81     71     64     63     1,920,000        2015-2024        Various        45     2 %-3% 

St. Mary’s Professional Office Building(11)
Reno, Nevada

    MOB        100     98     99     100     99     4,448,000        2015-2025        Various        28     2 %-3% 

Rosenberg Children’s Medical Plaza
Phoenix, Arizona

    MOB        99     99     100     100     100     1,989,000        2015-2019        Various        56     2 %-4% 

Phoenix Children’s East Valley Care Center Phoenix, Arizona

    MOB        100     100     100     100     100     936,000        2032        20        0     —     

Gold Shadow—700 Shadow(4)
Las Vegas, Nevada

    MOB        97     84     82     78     86     811,000        2015-2020        Various        38     2

Gold Shadow—2010 & 2020 Goldring MOBs(4) Las Vegas, Nevada

    MOB        64     92     95     95     91     889,000        2015-2021        Various        46     2 %-3% 

Centennial Hills MOB(4)
Las Vegas, Nevada

    MOB        71     62     62     63     58     1,459,000        2015-2024        Various        44     2 %-3% 

Suburban Medical Plaza II(11)
Louisville, Kentucky

    MOB        98     100     100     100     98     2,500,000        2015-2025        Various        21     3

Lake Pointe Medical Arts Building(6) Rowlett, Texas

    MOB        100     97     96     95     —          1,555,000        2017-2023        Various        24     3 %-4% 

Tuscan Medical Properties(6)
Las Colinas, Texas

    MOB        91     99     98     100     —          903,000        2015-2022        Various        100     2 %-3% 

PeaceHealth Medical Clinic(10)
Bellingham, Washington

    MOB        100     100     100     —          —          2,563,000        2021        20        100     1

 

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(1) Average occupancy rate for the hospital facilities is based on the average number of available beds occupied during each of the five years ended December 31, 2014. Average available beds is the number of beds which are actually in service at any given time for immediate patient use with the necessary equipment and staff available for patient care. A hospital may have appropriate licenses for more beds than are in service for a number of reasons, including lack of demand, incomplete construction and anticipation of future needs. The average occupancy rate of a hospital is affected by a number of factors, including the number of physicians using the hospital, changes in the number of beds, the composition and size of the population of the community in which the hospital is located, general and local economic conditions, variations in local medical and surgical practices and the degree of outpatient use of the hospital services. Average occupancy rate for the multi-tenant medical office buildings is based on the occupied square footage of each building, including any applicable master leases.
(2) In July, 2002, the operations of Inland Valley Regional Medical Center (“Inland Valley”) were merged with the operations of Rancho Springs Medical Center (“Rancho Springs”), an acute care hospital located in California and also operated by UHS, the real estate assets of which are not owned by us. Inland Valley, our lessee, was merged into Universal Health Services of Rancho Springs, Inc. The merged entity is now doing business as Southwest Healthcare System (“Southwest Healthcare”). As a result of merging the operations of the two facilities, the revenues of Southwest Healthcare include the revenues of both Inland Valley and Rancho Springs. Although we do not own the real estate assets of the Rancho Springs facility, Southwest Healthcare became the lessee on the lease relating to the real estate assets of the Inland Valley facility. Since the bonus rent calculation for the Inland Valley campus is based on net revenues and the financial results of the two facilities are no longer separable, the lease was amended during 2002 to exclude from the bonus rent calculation the estimated net revenues generated at the Rancho Springs campus (as calculated pursuant to a percentage based allocation determined at the time of the merger). The average occupancy rates shown for this facility for all years were based on the combined number of beds occupied at the Inland Valley and Rancho Springs campuses.
(3) During the first quarter of 2001, UHS purchased the assets and operations of the 60-bed McAllen Heart Hospital located in McAllen, Texas. Upon the acquisition by UHS, the Heart Hospital began operating under the same license as an integrated department of McAllen Medical Center. As a result of combining the operations of the two facilities, the revenues of McAllen Medical Center include revenues generated by the Heart Hospital, the real property of which is not owned by us. Accordingly, since the bonus rent calculation for McAllen Medical Center is based on the combined net revenues of the two facilities, the McAllen Medical Center lease was amended during 2001 to exclude from the bonus rent calculation, the estimated net revenues generated at the Heart Hospital (as calculated pursuant to a percentage based allocation determined at the time of the merger). In addition, during 2000, UHS purchased the South Texas Behavioral Health Center, a behavioral health care facility located in McAllen, Texas. In 2006, a newly constructed replacement facility for the South Texas Behavioral Health Center was completed and opened. The license for this facility, the real property of which is not owned by us, was also merged with the license for McAllen Medical Center. There was no amendment to the McAllen Medical Center lease related to the operations of the South Texas Behavioral Health Center and its revenues are excluded from the bonus rent calculation. In 2015, the newly constructed Weslaco and Mission Free Standing Emergency Departments (“FEDs”) were completed and opened. The license for these facilities is part of the license of McAllen Medical Center. The real property of these two FEDs was purchased by us and leased back to McAllen Medical Center. There was no amendment to the McAllen Medical Center lease related to the operations of the FEDs and their revenues will be excluded from the bonus rent calculation. No assurance can be given as to the effect, if any, the consolidation of the facilities as mentioned above, had on the underlying value of McAllen Medical Center. Base rental commitments and the guarantee by UHS under the original lease continue for the remainder of the lease terms. The average occupancy rates are based upon the combined occupancy and combined number of beds at McAllen Medical Center and McAllen Heart Hospital.
(4) The real estate assets of this facility are owned by us (either directly or through an LLC in which we hold 100% of the ownership interest) and include tenants who are subsidiaries of UHS.
(5) Minimum rent amounts contain impact of straight-line rent adjustments, if applicable.
(6) These properties were acquired in 2011.
(7) See Note 2 to the consolidated financial statements-Relationship with UHS and Related Party Transactions, regarding UHS’s purchase option, right of first refusal and change of control purchase option related to these properties.
(8) The lessee of this facility has a purchase option which is exercisable, subject to certain terms and conditions, at the expiration of each lease term. If exercised, the purchase option stipulates that the purchase price be the fair market value of the facility, subject to stipulated minimum and maximum prices. As currently being utilized, we believe the estimated current fair market value of the property is between the stipulated minimum and maximum prices. The lessee also has a first refusal to purchase right which, if applicable and subject to certain terms and conditions, grants the lessee the option to purchase the property at the same terms and conditions as an accepted third-party offer.

 

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(9) The lessee of this facility has a purchase option which is exercisable, subject to certain terms and conditions, at the expiration of each lease term. If exercised, the purchase option stipulates that the purchase price be the fair market value of the facility, subject to a stipulated minimum price. We believe the estimated current fair market value of the property exceeds the stipulated minimum price. The lessee also has a first refusal to purchase right which, if applicable and subject to certain terms and conditions, grants the lessee the option to purchase the property at the same terms and conditions as an accepted third-party offer.
(10) This MOB was acquired in January, 2012.
(11) The real estate assets of these facilities are owned by LLCs in which we hold non-controlling ownership interests (75% applicable to St. Mary’s Professional Office Building and 33% applicable to Suburban Medical Plaza II).

 

Leasing Trends at Our Significant Medical Office Buildings

 

During 2014, we had a total of 80 new or renewed leases related to the medical office buildings indicated above, in which we have significant investments, some of which are accounted for by the equity method. These leases comprised approximately 11% of the aggregate rentable square feet of these properties (6% related to renewed leases and 5% related to new leases). Rental rates, tenant improvement costs and rental concessions vary from property to property based upon factors such as, but not limited to, the current occupancy and age of our buildings, local overall economic conditions, proximity to hospital campuses and the vacancy rates, rental rates and capacity of our competitors in the market. The weighted-average tenant improvement costs associated with these new or renewed leases was approximately $22 per square foot during 2014. The weighted-average leasing commissions on the new and renewed leases commencing during 2014 was approximately 2% of base rental revenue over the term of the leases. The average aggregate value of the tenant concessions, generally consisting of rent abatements, provided in connection with new and renewed leases commencing during 2014 was approximately 2% of the future aggregate base rental revenue over the lease terms. Rent abatements were, or will be, recognized in our results of operations under the straight-line method over the lease term regardless of when payments are due. In connection with lease renewals executed during 2014, the weighted-average rental rates, as compared to rental rates on the expired leases, decreased by approximately 1%.

 

Set forth is information detailing the rentable square feet (“RSF”) associated with each of our investments as of December 31, 2014 and the percentage of RSF on which leases expire during the next five years and thereafter. For the MOBs that have scheduled lease expirations during 2015 of 20% or greater (of RSF), we have included information regarding estimated market rates relative to lease rates on the expiring leases.

 

                  Percentage of RSF with lease expirations  
     Total
RSF
     Available
for Lease
Jan. 1,
2015
    2015     2016     2017     2018     2019     2020
and
Later
 

Hospital Investements

               

McAllen Medical Center

     422,276         0     0     100     0     0     0     0

Wellington Regional Medical Center

     196,489         0     0     100     0     0     0     0

Southwest Healthcare System—Inland Valley Campus

     164,377         0     0     100     0     0     0     0

Kindred Hospital Chicago Central

     115,554         0     0     100     0     0     0     0

HealthSouth Deaconess Rehab. Hospital

     77,440         0     0     0     0     0     100     0

Vibra Hospital of Corpus Christi

     69,700         0     0     0     0     0     100     0
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Sub-total Hospitals

     1,045,836         0     0     86     0     0     14     0
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other Investements

               

Medical Office Buildings:

               

Saint Mary’s Professional Office Building

     190,754         0     5     1     8     0     2     84

Goldshadow—2010—2020 Goldring MOB’s(a)

     74,774         32     21     5     21     2     0     19

Goldshadow—700 Shadow Lane MOB(a)

     42,060         3     45     6     11     0     12     23

Texoma Medical Plaza

     115,284         4     10     0     2     6     2     76

Suburban Medical Plaza II

     103,011         4     2     9     1     6     2     76

Desert Springs Medical Plaza

     102,579         44     13     2     0     6     8     27

Peace Health Medical Clinic

     98,886         0     0     0     0     0     0     100

Centennial Hills Medical Office Building

     96,573         26     7     6     2     13     5     41

Summerlin Hospital Medical Office Building II(a)

     92,313         23     20     7     14     9     16     11

Summerlin Hospital Medical Office Building I(a)

     89,636         38     23     23     4     4     2     6

The Sparks Medical Building

     35,127         8     9     13     4     6     3     57

Vista Medical Terrace

     50,921         50     9     1     10     9     7     14

North Valley Medical Plaza

     80,379         59     14     5     4     10     3     5

Summerlin Hospital Medical Office Building III

     77,713         0     2     13     0     6     44     35

 

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Table of Contents
                  Percentage of RSF with lease expirations  
     Total
RSF
     Available
for Lease
Jan. 1,
2015
    2015     2016     2017     2018     2019     2020
and
Later
 

Mid Coast Hospital MOB

     74,629         0     0     77     0     7     0     16

Sheffield Medical Building

     73,446         58     3     5     8     0     4     22

North West Texas Professional Office Tower

     72,351         0     3     46     3     0     0     48

Rosenberg Children’s Medical Plaza

     66,231         1     3     17     0     74     5     0

Sierra San Antonio Medical Plaza

     59,160         32     4     6     9     7     3     39

Palmdale Medical Plaza

     58,150         47     0     0     5     9     0     39

Spring Valley Medical Office Building

     57,828         40     19     11     21     9     0     0

Spring Valley Medical Office Building II

     57,432         17     0     13     0     39     14     17

Southern Crescent Center II

     53,680         35     0     11     0     0     15     39

Desert Valley Medical Center

     53,625         21     14     15     9     11     0     30

Tuscan Professional Building

     52,868         12     17     8     0     12     0     51

Lake Pointe Medical Arts Building

     50,974         0     0     0     33     23     14     30

Forney Medical Plaza

     50,947         9     0     0     0     80     0     11

Southern Crescent Center I

     41,897         46     0     0     6     21     27     0

Auburn Medical Office Building

     41,311         10     0     0     9     0     0     81

BRB Medical Office Building

     40,733         0     17     4     0     9     3     67

Cypresswood Professiona Center—8101(b)

     10,200         0     100     0     0     0     0     0

Cypresswood Professional Center—8111

     29,882         5     7     0     11     0     16     61

Medical Center of Western Connecticut

     36,141         0     0     4     24     5     67     0

Phoenix Children’s East Valley Care Center

     30,960         0     0     0     0     0     0     100

Forney Medical Plaza II

     30,507         67     0     0     0     5     0     28

Apache Junction Medical Plaza

     26,901         31     9     4     22     0     0     34

Santa Fe Professional Plaza

     24,883         28     0     27     11     11     0     23

Professional Bldg at King’s Crossing—Bldg A (d)

     11,528         100     0     0     0     0     0     0

Professional Bldg at King’s Crossing—Bldg B(c)

     12,790         0     36     41     11     0     12     0

The Children’s Clinic at Springdale

     9,761         0     0     0     0     0     0     100

Northwest Medical Center at Sugar Creek

     13,696         0     0     0     0     0     0     100

Kelsey-Seybold Clinic at King’s Crossing

     20,470         0     0     0     0     0     0     100

Emory at Dunwoody Building

     20,366         0     0     0     0     0     0     100

Ward Eagle Office Village

     16,282         0     0     0     0     0     0     100

Family Doctor’s MOB

     12,050         0     0     100     0     0     0     0

701 South Tonopah Building

     10,747         0     0     0     0     0     0     100

5004 Pool Road MOB

     4,400         0     0     0     0     0     0     100

Preschool and Childcare Centers:

               

Chesterbrook Academy—Audubon

     8,300         0     0     0     0     0     0     100

Chesterbrook Academy—Uwchlan

     8,163         0     0     0     0     0     0     100

Chesterbrook Academy—Newtown

     8,100         0     0     100     0     0     0     0

Chesterbrook Academy—New Britain

     7,998         0     0     100     0     0     0     0

Free-Standing Emergency Departments:

               

Hanover Freestanding Emergency Center

     22,000         0     0     0     0     0     0     100
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Sub-total Other Investments

     2,531,397         19     8     10     6     9     6     42
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

     3,577,233         13     6     32     4     7     8     30
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a) The estimated market rates related to the 2015 expiring RSF are greater than the lease rates on the expiring leases by an average of approximately 3%.
(b) The estimated market rates related to the 2015 expiring RSF are less than the lease rates on the expiring leases by an average of approximately 5%.
(c) The estimated market rates related to the 2015 expiring RSF are less than the lease rates on the expiring leases by an average of approximately 11%.
(d) A new lease was executed on this building subsequent to January 1, 2015 for 100% of the available space on January 1, 2015.

 

On a combined basis, based upon the aggregate revenues and square footage for the hospital facilities owned as of December 31, 2014 (including The Bridgeway which was sold on December 31, 2014) and 2013, the average effective annual rental per square foot was $17.47 and $17.22, respectively. On a combined basis, based upon the aggregate consolidated and unconsolidated revenues and the estimated average occupied square footage for our MOBs and childcare centers owned as of December 31, 2014 and 2013, the average effective annual rental per square foot was $27.22 and $27.47, respectively. On a combined basis, based upon the aggregate consolidated and unconsolidated revenues and estimated average occupied square footage for all of our properties owned as of December 31, 2014 and 2013, the average effective annual rental per square foot was $23.83 and $23.82, respectively. The estimated average occupied square footage for 2014 was calculated by averaging the unavailable rentable square footage on January 1, 2014 and January 1, 2015. The estimated average occupied square footage for 2013 was calculated by averaging the unavailable rentable square footage on January 1, 2013 and January 1, 2014.

 

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During 2014, one of the UHS-related hospitals (McAllen Medical Center) generated revenues that comprised more than 10% of our consolidated revenues. None of the properties had book values greater than 10% of our consolidated assets as of December 31, 2014. Including 100% of the revenues generated at the properties owned by our unconsolidated LLCs, none of our unconsolidated LLCs had revenues greater than 10% of the combined consolidated and unconsolidated revenues during 2014. Including 100% of the book values of the properties owned by our unconsolidated LLCs, none of the properties had book values greater than 10% of the consolidated and unconsolidated assets.

 

The following table sets forth the average effective annual rental per square foot for 2014, based upon average occupied square feet for McAllen Medical Center:

 

Property

   2014
Average
Occupied
Square
Feet
     2014
Revenues
     2014
Average
Effective
Rental
Per Square
Foot
 

McAllen Medical Center

     422,276       $ 7,121,000       $ 16.86   

 

The following table sets forth lease expirations for each of the next ten years for properties owned or invested in as of December 31, 2014.

 

     Expiring
Square
Feet
     Number
of
Tenants
     Annual Rentals of
Expiring
Leases(1)
     Percentage
of
Annual
Rentals(2)
 

Hospital properties

           

2015

     0         0       $ 0         0

2016

     898,696         4       $ 12,414,000         17

2017

     0         0       $ 0         0

2018

     0         0       $ 0         0

2019

     147,140         2       $ 1,491,000         2

2020

     0         0       $ 0         0

2021

     0         0       $ 0         0

2022

     0         0       $ 0         0

2023

     0         0       $ 0         0

2024

     0         0       $ 0         0

Thereafter

     0         0       $ 0         0
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal-hospital facilities

     1,045,836         6       $ 13,905,000         19
  

 

 

    

 

 

    

 

 

    

 

 

 

Other consolidated properties

           

2015

     176,967         68       $ 4,764,000         7

2016

     188,920         54       $ 4,864,000         7

2017

     126,827         45       $ 3,219,000         4

2018

     220,209         56       $ 7,855,000         11

2019

     137,163         34       $ 3,981,000         6

2020

     166,357         38       $ 5,026,000         7

2021

     200,366         23       $ 5,612,000         8

2022

     124,565         13       $ 2,994,000         4

2023

     91,357         18       $ 2,671,000         4

2024

     42,544         4       $ 1,209,000         1

Thereafter

     86,506         9       $ 2,253,000         3
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal-other consolidated properties

     1,561,781         362       $ 44,448,000         62
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents
     Expiring
Square
Feet
     Number
of
Tenants
     Annual Rentals of
Expiring
Leases(1)
     Percentage
of
Annual
Rentals(2)
 

Other unconsolidated properties

(MOBs)

           

2015

     84,344         7       $ 2,221,000         3

2016

     11,976         9       $ 330,000         0

2017

     19,146         6       $ 558,000         1

2018

     19,434         6       $ 560,000         1

2019

     7,333         3       $ 208,000         0

2020

     135,931         11       $ 3,906,000         5

2021

     16,915         5       $ 459,000         1

2022

     27,802         6       $ 755,000         1

2023

     24,808         6       $ 815,000         1

2024

     47,394         8       $ 1,397,000         2

Thereafter

     94,948         8       $ 2,716,000         4
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal-other unconsolidated properties

     490,031         75       $ 13,925,000         19
  

 

 

    

 

 

    

 

 

    

 

 

 

Total all properties at December 31, 2014

     3,097,648         443       $ 72,278,000         100
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The annual rentals of expiring leases reflected above were calculated based upon each property’s 2014 average rental rate per occupied square foot applied to each property’s scheduled lease expirations (on a square foot basis). These amounts include the data related to the unconsolidated LLCs in which we hold various non-controlling ownership interests at December 31, 2014 and exclude the bonus rentals earned on the UHS hospital facilities.
(2) The percentages of annual rentals reflected above were calculated based upon the annual rentals of expiring leases (as reflected above) divided by the total annual rentals of expiring leases (as reflected above).

 

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Table of Contents
ITEM 3. Legal Proceedings

 

None

 

ITEM 4. Mine Safety Disclosures

 

Not applicable

 

PART II

 

ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

Our shares of beneficial interest are listed on the New York Stock Exchange. The high and low closing sales prices for our shares of beneficial interest for each quarter in the years ended December 31, 2014 and 2013 are summarized below:

 

     2014      2013  
     High
Price
     Low
Price
     High
Price
     Low
Price
 

First Quarter

   $ 44.21       $ 40.03       $ 58.03       $ 51.82   

Second Quarter

   $ 44.55       $ 41.73       $ 58.85       $ 41.47   

Third Quarter

   $ 44.74       $ 41.26       $ 46.53       $ 38.52   

Fourth Quarter

   $ 49.13       $ 41.47       $ 45.60       $ 40.06   

 

Holders

 

As of January 31, 2015, there were approximately 380 shareholders of record of our shares of beneficial interest.

 

Dividends

 

It is our intention to declare quarterly dividends to the holders of our shares of beneficial interest so as to comply with applicable sections of the Internal Revenue Code governing REITs. Our revolving credit facility limits our ability to increase dividends in excess of 95% of cash available for distribution, as defined in our revolving credit agreement, unless additional distributions are required to be made so as to comply with applicable sections of the Internal Revenue Code and related regulations governing REITs. In each of the past two years, dividends per share were declared as follows:

 

     2014      2013  

First Quarter

   $ .625       $ .620   

Second Quarter

     .630         .625   

Third Quarter

     .630         .625   

Fourth Quarter

     .635         .625   
  

 

 

    

 

 

 
   $ 2.520       $ 2.495   
  

 

 

    

 

 

 

 

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Table of Contents

Stock Price Performance Graph

 

The following graph compares our performance with that of the S&P 500 and a group of peer companies, where performance has been weighted based on market capitalization. Companies in our peer group are as follows: HCP, Inc., Nationwide Health Properties, Inc. (included until July, 2011 when it was acquired by Ventas, Inc.), Omega Healthcare Investors, Inc., Health Care REIT, Inc., Healthcare Realty Trust, Inc., LTC Properties, Inc., and National Health Investors, Inc.

 

The total cumulative return on investment (change in the year-end stock price plus reinvested dividends) for each of the periods for us, the peer group and the S&P 500 composite is based on the stock price or composite index at the end of fiscal 2009.

 

LOGO

 

     Base
Period
Dec 09
     INDEXED RETURNS
Years Ending
 

Company Name / Index

      Dec 10      Dec 11      Dec 12      Dec 13      Dec 14  

Universal Health Realty Income Trust

   $ 100       $ 122.24       $ 139.02       $ 190.69       $ 159.53       $ 202.90   

S&P 500 Index

   $ 100       $ 115.06       $ 117.49       $ 136.30       $ 180.44       $ 205.14   

Peer Group

   $ 100       $ 119.16       $ 137.75       $ 163.34       $ 149.74       $ 205.10   

 

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ITEM 6. Selected Financial Data

 

The following table contains our selected financial data for, or at the end of, each of the five years ended December 31, 2014. You should read this table in conjunction with our consolidated financial statements and related notes contained elsewhere in this Annual Report and Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

     (000s, except per share amounts)  
     2014     2013     2012     2011     2010  

Operating Results:

          

Total revenues(1)

   $ 59,786      $ 54,280      $ 53,950      $ 29,494      $ 28,878   

Net income(2)

   $ 51,551      $ 13,169      $ 19,477      $ 73,794      $ 16,310   

Balance Sheet Data:

          

Real estate investments, net of accumulated depreciation(1)(3)

   $ 380,109      $ 297,748      $ 314,386      $ 288,633      $ 125,257   

Investments in LLCs, net(1)(4)

     8,605        39,201        28,636        33,057        80,442   

Intangible assets, net of accumulated amortization(3)

     23,123        20,782        26,293        28,081        1,080   

Total assets(1)(3)

     428,866        373,145        383,038        370,929        216,135   

Total indebtedness, including debt premium(1)(3)(5)

     213,155        199,987        197,936        174,836        67,563   

Other Data:

          

Funds from operations(6)

   $ 35,937      $ 34,955      $ 34,280      $ 32,468      $ 32,582   

Cash provided by (used in):

          

Operating activities

     32,796        31,294        30,783        21,372        23,049   

Investing activities

     (4,038     (13,373     (8,565     (7,454     (15,202

Financing activities

     (29,815     (17,491     (30,819     (7,426     (7,798

Per Share Data:

          

Basic earnings per share:

          

Total basic earnings per share(2)

   $ 3.99      $ 1.04      $ 1.54      $ 5.84      $ 1.33   

Diluted earnings per share:

          

Total diluted earnings per share(2)

   $ 3.99      $ 1.04      $ 1.54      $ 5.83      $ 1.33   

Dividends per share

   $ 2.520      $ 2.495      $ 2.460      $ 2.425      $ 2.415   

Other Information (in thousands)

          

Weighted average number of shares outstanding—basic

     12,927        12,689        12,661        12,644        12,259   

Weighted average number of shares and share equivalents outstanding—diluted

     12,934        12,701        12,669        12,649        12,262   

 

(1) As discussed in Note 1 “Summary of Significant Accounting Policies—Investments in Limited Liability Companies”, our consolidated financial statements include the consolidated accounts of our consolidated investments and those investments that meet the criteria of a variable interest entity. Please see Note 1 for further discussions.
(2)

Net income and earnings per share during 2014 includes: (i) a $25.4 million gain recorded in connection with our purchase of third-party minority ownership interests in eight LLCs (January and August, 2014, as discussed below) in which we formerly held non-controlling majority ownership interests (we own 100% of each of these entities since the effective dates); (ii) a $13.0 million gain on the divestiture of real property (the Bridgeway), and; (iii) $427,000 of transaction costs related to the 2014 acquisition and divestiture activity previously mentioned. Net income and earnings per share during 2013 includes approximately $200,000 of transaction costs related to the acquisition of three MOBs during 2013 and the first quarter of 2014. Net income and earnings per share during 2012 includes an $8.5 million gain on the divestitures of properties owned by two unconsolidated LLCs in which we formerly held non-controlling majority ownership interests, and $680,000 of transaction costs related to the acquisition of a medical clinic and

 

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medical office building in 2012. Net income and earnings per share data during 2011 includes: (i) a $28.6 million gain recorded in connection with our purchase of third-party minority ownership interests in various LLCs in which we formerly held non-controlling majority ownership interests (we own 100% of each of these entities since that time); (ii) a $35.8 million gain on the divestitures of properties owned by unconsolidated LLCs in which we formerly held non-controlling majority ownership interests; (iii) $518,000 of transaction costs related to the acquisition of four MOBs during 2011 and the first quarter of 2012, and; (iv) a $5.4 million charge for a provision for asset impairment recorded on a certain MOB.

(3) Amounts include: (i) the fair value of the real property (as of 2014) of the eight previously unconsolidated LLCs, which we began consolidating during the first and third quarters of 2014, subsequent to our purchase of the third-party minority ownership interests on January 1, 2014 and August 1, 2014 (we owned 100% of each of these entities at December 31, 2014), and; (ii) the fair values of the real property (as of 2011) of various previously unconsolidated LLCs, which we began consolidating during the fourth quarter of 2011 subsequent to our purchase of the third-party minority ownership interests (we owned 100% of each of these entities at December 31, 2011).
(4) Investments in LLCs at December 31, 2014, 2013, 2012 and 2011 reflect the consolidation of various LLCs, as mentioned in notes 2 and 3 above, as well as the divestiture of property owned by various unconsolidated LLCs during 2012 and 2011. Additionally, at December 31, 2013, Investments in LLCs reflects the deconsolidation of Palmdale Medical Properties. This LLC was deemed to be a variable interest entity during the term of the master lease and was consolidated in our financial statements through June 30, 2013 since we were the primary beneficiary through that date. Effective July 1, 2013, this LLC is no longer be deemed a variable interest entity and is accounted for in our financial statements on an unconsolidated basis pursuant to the equity method. Effective January 1, 2014, Investments in LLCs reflects the consolidation of Palmdale Medical Properties, since we purchased the third-party minority ownership interests in Palmdale and began accounting for this LLC on a consolidated basis as of that date.
(5) Excludes third-party debt that is non-recourse to us, incurred by unconsolidated LLCs in which we hold various non-controlling equity interests as follows: $52.7 million as of December 31, 2014, $80.1 million as of December 31, 2013, $77.5 million as of December 31, 2012, $101.8 million as of December 31, 2011 and $271.7 million as of December 31, 2010 (See Note 8 to the consolidated financial statements).
(6) Our funds from operations (“FFO”) during 2014, 2013, 2012 and 2011 are net of reductions for transaction costs of $427,000, $203,000, $680,000 and $518,000, respectively.

 

Funds from operations (“FFO”) is a widely recognized measure of performance for Real Estate Investment Trusts (“REITs”). We believe that FFO and FFO per diluted share, and adjusted funds from operations (“AFFO”) and AFFO per diluted share, which are non-GAAP financial measures (“GAAP” is Generally Accepted Accounting Principles in the United States of America), are helpful to our investors as measures of our operating performance. We compute FFO, as reflected below, in accordance with standards established by the National Association of Real Estate Investment Trusts (“NAREIT”), which may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we interpret the definition. AFFO was also computed for 2014, 2013, 2012, 2011 and 2010, as reflected below, since we believe it is helpful to our investors since it adjusts for the transaction costs related to acquisitions. FFO/AFFO do not represent cash generated from operating activities in accordance with GAAP and should not be considered to be an alternative to net income determined in accordance with GAAP. In addition, FFO/AFFO should not be used as: (i) an indication of our financial performance determined in accordance with GAAP; (ii) an alternative to cash flow from operating activities determined in accordance with GAAP; (iii) a measure of our liquidity, or; (iv) an indicator of funds available for our cash needs, including our ability to make cash distributions to shareholders.

 

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Table of Contents

A reconciliation of our reported net income to FFO and AFFO for each of the last five years is shown below:

 

     (000s)  
     2014     2013      2012     2011     2010  

Net income

   $ 51,551      $ 13,169       $ 19,477      $ 73,794      $ 16,310   

Depreciation and amortization expense on real property/intangibles:

         

Consolidated investments

     20,548        18,496         20,030        7,173        6,156   

Unconsolidated affiliates

     2,290        3,290         3,293        10,558        10,116   

Provision for asset impairment

     —         —          —         5,354        —    

Less gains:

         

Gains on fair value recognition resulting from the purchase of minority interests in majority-owned LLCs, net

     (25,409 )     —          —         (28,576     —    

Gain on divestiture of real property

     (13,043     —          —         —         —    

Gains on divestiture of properties owned by unconsolidated LLCs, net

     —         —          (8,520     (35,835     —    
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Funds From Operations

     35,937        34,955         34,280        32,468        32,582   

Transaction costs

     427        203         680        518        —    
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Adjusted Funds From Operations

   $ 36,364      $ 35,158       $ 34,960      $ 32,986      $ 32,582   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

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Table of Contents
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

We are a real estate investment trust (“REIT”) that commenced operations in 1986. We invest in healthcare and human service related facilities currently including acute care hospitals, rehabilitation hospitals, sub-acute facilities, surgery centers, free-standing emergency departments, childcare centers and medical office buildings (“MOBs”). As of February 28, 2015, we have sixty-one real estate investments or commitments in eighteen states consisting of:

 

   

six hospital facilities including three acute care, one rehabilitation and two sub-acute;

 

   

three free-standing emergency departments;

 

   

forty-eight medical office buildings (“MOBs”), including five owned by unconsolidated LLCs, and;

 

   

four preschool and childcare centers.

 

Forward Looking Statements

 

This report contains “forward-looking statements” that reflect our current estimates, expectations and projections about our future results, performance, prospects and opportunities. Forward-looking statements include, among other things, the information concerning our possible future results of operations, business and growth strategies, financing plans, expectations that regulatory developments or other matters will not have a material adverse effect on our business or financial condition, our competitive position and the effects of competition, the projected growth of the industry in which we operate, and the benefits and synergies to be obtained from our completed and any future acquisitions, and statements of our goals and objectives, and other similar expressions concerning matters that are not historical facts. Words such as “may,” “will,” “should,” “could,” “would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” “appears,” “projects” and similar expressions, as well as statements in future tense, identify forward-looking statements.

 

Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, such performance or results will be achieved. Forward-looking information is based on information available at the time and/or our good faith belief with respect to future events, and is subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in the statements. Such factors include, among other things, the following:

 

   

a substantial portion of our revenues are dependent upon one operator, Universal Health Services, Inc. (“UHS”). We cannot assure you that subsidiaries of UHS will renew the leases on our three acute care hospitals at existing lease rates or fair market value lease rates. In addition, if subsidiaries of UHS exercise their options to purchase the respective leased hospital facilities upon expiration of the lease terms, our future revenues and results of operations could decrease if we were unable to earn a favorable rate of return on the sale proceeds received, as compared to the rental revenue currently earned pursuant to the hospital leases;

 

   

a number of legislative initiatives have recently been passed into law that may result in major changes in the health care delivery system on a national or state level to the operators of our facilities, including UHS. No assurances can be given that the implementation of these new laws will not have a material adverse effect on the business, financial condition or results of operations of our operators;

 

   

a subsidiary of UHS is our Advisor and our officers are all employees of a wholly-owned subsidiary of UHS, which may create the potential for conflicts of interest;

 

   

lost revenues resulting from the exercise of purchase options, lease expirations and renewals, loan repayments and other restructuring;

 

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our ability to continue to obtain capital on acceptable terms, including borrowed funds, to fund future growth of our business. Our $150 million revolving credit agreement is scheduled to expire on July 24, 2015. We are in the process of renegotiating our Credit Agreement and, although we can provide no assurance we will do so, we expect to complete the replacement credit facility by March 31, 2015;

 

   

the outcome of known and unknown litigation, government investigations, and liabilities and other claims asserted against us or the operators of our facilities;

 

   

failure of the operators of our hospital facilities to comply with governmental regulations related to the Medicare and Medicaid licensing and certification requirements could have a material adverse impact on our future revenues and the underlying value of the property;

 

   

the potential unfavorable impact on our business of deterioration in national, regional and local economic and business conditions, including a worsening of credit and/or capital market conditions, which may adversely affect, our ability to obtain capital which may be required to fund the future growth of our business and refinance existing debt with near term maturities;

 

   

a deterioration in general economic conditions which could result in increases in the number of people unemployed and/or insured and likely increase the number of individuals without health insurance; as a result, the operators of our facilities may experience decreases in patient volumes which could result in decreased occupancy rates at our medical office buildings;

 

   

a worsening of the economic and employment conditions in the United States could materially affect the business of our operators, including UHS, which may unfavorably impact our future bonus rentals (on the UHS hospital facilities) and may potentially have a negative impact on the future lease renewal terms and the underlying value of the hospital properties;

 

   

real estate market factors, including without limitation, the supply and demand of office space and market rental rates, changes in interest rates as well as an increase in the development of medical office condominiums in certain markets;

 

   

government regulations, including changes in the reimbursement levels under the Medicare and Medicaid program resulting from, among other things, the various health care reform initiatives being implemented;

 

   

there have been several attempts in Congress to repeal or modify various provisions of the Patient Protection and Affordable Care Act (the “PPACA”). We cannot predict whether or not any of these proposed changes to the PPACA will become law and therefore can provide no assurance that changes to the PPACA, as currently implemented, will not have a material adverse effect on the future operating results of the tenants/operators of our properties and, thus, our business. In addition, a case currently pending before The Supreme Court of the United States, King vs. Burwell, challenges the federal government’s ability to subsidize premiums paid by certain eligible individuals that obtain health insurance policies through federally facilitated exchanges. A number of our properties are located in states that utilize federally facilitated exchanges. The Supreme Court of the United States’ decision in this case could result in an increased number of uninsured patients in the states that utilize federally facilitated exchanges which would have an adverse impact on the future operating results of the tenants/operators of our facilities located in these states and, thus, our business;

 

   

the issues facing the health care industry that affect the operators of our facilities, including UHS, such as: changes in, or the ability to comply with, existing laws and government regulations; unfavorable changes in the levels and terms of reimbursement by third party payors or government programs, including Medicare (including, but not limited to, the potential unfavorable impact of future reductions to Medicare reimbursements resulting from the Budget Control Act of 2011, as discussed below) and Medicaid (most states have reported significant budget deficits that have, in the past, resulted in the reduction of Medicaid funding to the operators of our facilities, including UHS); demographic changes; the ability to enter into managed care provider agreements on acceptable terms; an increase in uninsured and self-pay patients which unfavorably impacts the collectability of patient accounts;

 

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decreasing in-patient admission trends; technological and pharmaceutical improvements that may increase the cost of providing, or reduce the demand for, health care, and; the ability to attract and retain qualified medical personnel, including physicians;

 

   

in August, 2011, the Budget Control Act of 2011 (the “2011 Act”) was enacted into law. The 2011 Act imposed annual spending limits for most federal agencies and programs aimed at reducing budget deficits by $917 billion between 2012 and 2021, according to a report released by the Congressional Budget Office. The 2011 Act provides for new spending on program integrity initiatives intended to reduce fraud and abuse under the Medicare program. Among its other provisions, the law established a bipartisan Congressional committee, known as the Joint Select Committee on Deficit Reduction (the “Joint Committee”), which was tasked with making recommendations aimed at reducing future federal budget deficits by an additional $1.5 trillion over 10 years. The Joint Committee was unable to reach an agreement by the November 23, 2011 deadline and, as a result, across-the-board cuts to discretionary, national defense and Medicare spending were implemented on March 1, 2013 resulting in Medicare payment reductions of up to 2% per fiscal year with a uniform percentage reduction across all Medicare programs. We cannot predict whether Congress will restructure the implemented Medicare payment reductions or what federal other deficit reduction initiatives may be proposed by Congress. We also cannot predict the effect this enactment will have on operators (including UHS), and, thus, our business;

 

   

in March, 2010, the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act were enacted into law and created significant changes to health insurance coverage for U.S. citizens as well as material revisions to the federal Medicare and state Medicaid programs. The two combined primary goals of these acts are to provide for increased access to coverage for healthcare and to reduce healthcare-related expenses. Medicare, Medicaid and other health care industry changes are scheduled to be implemented at various times during this decade. We cannot predict the effect, if any, these enactments will have on operators (including UHS) and, thus, our business;

 

   

two of our MOBs, which are located in California, could not obtain earthquake insurance at rates which are economically beneficial in relation to the risks covered;

 

   

competition for our operators from other REITs;

 

   

the operators of our facilities face competition from other health care providers, including physician owned facilities and other competing facilities, including certain facilities operated by UHS but the real property of which is not owned by us. Such competition is experienced in markets including, but not limited to, McAllen, Texas, the site of our McAllen Medical Center, a 430-bed acute care hospital, and Riverside County, California, the site of our Southwest Healthcare System-Inland Valley Campus, a 132-bed acute care hospital;

 

   

changes in, or inadvertent violations of, tax laws and regulations and other factors than can affect REITs and our status as a REIT;

 

   

should we be unable to comply with the strict income distribution requirements applicable to REITs, utilizing only cash generated by operating activities, we would be required to generate cash from other sources which could adversely affect our financial condition;

 

   

our majority ownership interests in five LLCs in which we hold non-controlling equity interests. In addition, pursuant to the operating and/or partnership agreements of most of the five LLCs in which we continue to hold non-controlling majority ownership interests, the third-party member and the Trust, at any time, have the right to make an offer (“Offering Member”) to the other member(s) (“Non-Offering Member”) in which it either agrees to: (i) sell the entire ownership interest of the Offering Member to the Non-Offering Member (“Offer to Sell”) at a price as determined by the Offering Member (“Transfer Price”), or; (ii) purchase the entire ownership interest of the Non-Offering Member (“Offer to Purchase”) at the equivalent proportionate Transfer Price. The Non-Offering Member has 60 to 90

 

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days to either: (i) purchase the entire ownership interest of the Offering Member at the Transfer Price, or; (ii) sell its entire ownership interest to the Offering Member at the equivalent proportionate Transfer Price. The closing of the transfer must occur within 60 to 90 days of the acceptance by the Non-Offering Member;

 

   

fluctuations in the value of our common stock, and;

 

   

other factors referenced herein or in our other filings with the Securities and Exchange Commission.

 

Given these uncertainties, risks and assumptions, you are cautioned not to place undue reliance on such forward-looking statements. Our actual results and financial condition, including the operating results of our lessees and the facilities leased to subsidiaries of UHS, could differ materially from those expressed in, or implied by, the forward-looking statements.

 

Forward-looking statements speak only as of the date the statements are made. We assume no obligation to publicly update any forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except as may be required by law. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this cautionary statement.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes.

 

A summary of our critical accounting policies is outlined in Note 1 to the consolidated financial statements. We consider our critical accounting policies to be those that require us to make significant judgments and estimates when we prepare our financial statements, including the following:

 

Revenue Recognition:    Our revenues consist primarily of rentals received from tenants, which are comprised of minimum rent (base rentals), bonus rentals and reimbursements from tenants for their pro-rata share of expenses such as common area maintenance costs, real estate taxes and utilities.

 

The minimum rent for all hospital facilities is fixed over the initial term or renewal term of the respective leases. Rental income recorded by our properties, including our consolidated and unconsolidated MOBs, relating to leases in excess of one year in length, is recognized using the straight-line method under which contractual rents are recognized evenly over the lease term regardless of when payments are due. The amount of rental revenue resulting from straight-line rent adjustments is dependent on many factors including the nature and amount of any rental concessions granted to new tenants, stipulated rent increases under existing leases, as well as the acquisitions and sales of properties that have existing in-place leases with terms in excess of one year. As a result, the straight-line adjustments to rental revenue may vary from period-to-period. Bonus rents are recognized when earned based upon increases in each facility’s net revenue in excess of stipulated amounts. Bonus rentals are determined and paid each quarter based upon a computation that compares the respective facility’s current quarter’s net revenue to the corresponding quarter in the base year. Tenant reimbursements for operating expenses are accrued as revenue in the same period the related expenses are incurred.

 

Real Estate Investments:    On the date of acquisition, the purchase price of a property is allocated to the property’s land, buildings and intangible assets based upon our estimates of their fair values. Depreciation is computed using the straight-line method over the useful lives of the buildings and capital improvements. The value of intangible assets is amortized over the remaining lease term.

 

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Asset Impairment:    Real estate investments and related intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the property might not be recoverable. A property to be held and used is considered impaired only if management’s estimate of the aggregate future cash flows, less estimated capital expenditures, to be generated by the property, undiscounted and without interest charges, are less than the carrying value of the property. This estimate takes into consideration factors such as expected future operating income, trends and prospects, as well as the effects of demand, competition, local market conditions and other factors.

 

The determination of undiscounted cash flows requires significant estimates by management, including the expected course of action at the balance sheet date that would lead to such cash flows. Subsequent changes in estimated undiscounted cash flows arising from changes in anticipated action to be taken with respect to the property could impact the determination of whether an impairment exists and whether the effects could materially impact our net income. To the extent estimated undiscounted cash flows are less than the carrying value of the property, the loss will be measured as the excess of the carrying amount of the property over the fair value of the property.

 

Assessment of the recoverability by us of certain lease related costs must be made when we have reason to believe that a tenant might not be able to perform under the terms of the lease as originally expected. This requires us to make estimates as to the recoverability of such costs. If we determine that the intangible assets are not recoverable from future cash flows, the excess of carrying value of the intangible asset over its estimated fair value is charged to income.

 

An other than temporary impairment of an investment/advance in an LLC is recognized when the carrying value of the investment is not considered recoverable based on evaluation of the severity and duration of the decline in value, including projected declines in cash flow. To the extent impairment has occurred, the excess carrying value of the asset over its estimated fair value is charged to income.

 

Investments in Limited Liability Companies (“LLCs”):    Our consolidated financial statements include the consolidated accounts of our controlled investments and those investments that meet the criteria of a variable interest entity where we are the primary beneficiary. In accordance with the FASB’s standards and guidance relating to accounting for investments and real estate ventures, we account for our unconsolidated investments in LLCs which we do not control using the equity method of accounting. The third-party members in these investments have equal voting rights with regards to issues such as, but not limited to: (i) divestiture of property; (ii) annual budget approval, and; (iii) financing commitments. These investments, which represent 33% to 95% non-controlling ownership interests, are recorded initially at our cost and subsequently adjusted for our net equity in the net income, cash contributions to, and distributions from, the investments. Pursuant to certain agreements, allocations of sales proceeds and profits and losses of some of the LLC investments may be allocated disproportionately as compared to ownership interests after specified preferred return rate thresholds have been satisfied.

 

At December 31, 2014, we have non-controlling equity investments or commitments in five jointly-owned LLCs which own medical office buildings. These LLCs are included in our financial statements for all periods presented on an unconsolidated basis pursuant to the equity method since they are not variable interest entities. These LLCs are joint-ventures between us and non-related parties that manage and hold minority ownership interests in the entities. Each LLC is generally self-sustained from a cash flow perspective and generates sufficient cash flow to meet its operating cash flow requirements and service the third-party debt (if applicable) that is non-recourse to us. Although there is typically no ongoing financial support required from us to these entities since they are cash-flow sufficient, we may, from time to time, provide funding for certain purposes such as, but not limited to, significant capital expenditures, leasehold improvements and debt financing. Although we are not obligated to do so, if approved by us at our sole discretion, additional cash fundings are typically advanced as equity or member loans.

 

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Palmdale Medical Properties was consolidated in our financial statements through June 30, 2013 at which time its master lease with a wholly-owned subsidiary of UHS expired. For the period of July 1, 2013 through December 31, 2013, we accounted for Palmdale Medical Properties under the equity method. As discussed below, as a result of our purchase of the third-party minority ownership interest in Palmdale Medical Properties, effective January 1, 2014, we began accounting for Palmdale Medical Properties on a consolidated basis.

 

Effective August 1, 2014, we purchased the third-party minority ownership interests, ranging from 5% to 15%, in six LLCs (Desert Valley Medical Center, Santa Fe Professional Plaza, Rosenberg Children’s Medical Plaza, Sierra San Antonio Medical Plaza, Phoenix Children’s East Valley Care Center and 3811 E. Bell Medical Building Medical Plaza). Effective January 1, 2014, we purchased the third-party minority ownership interests (5% for each LLC) in Palmdale Medical Properties and Sparks Medical Properties. We formerly held non-controlling majority ownership interests in all of these LLCs, and as a result of our purchase of the minority ownership interests, we now hold 100% of the ownership interests in these LLCs which own MOBs. As a result, we began accounting for the six LLCs mentioned above on a consolidated basis effective August 1, 2014 and we began accounting for Palmdale Medical Properties and Sparks Medical Properties on a consolidated basis effective January 1, 2014, as discussed below. Each of the property’s assets and liabilities were recorded at their fair values (see Note 3 to the consolidated financial statements for additional disclosure). Other than an increase in depreciation and amortization expense resulting from the fair value recognition related to the purchase of the minority ownership interests, we do not expect these transactions to have a material impact on our future results of operations.

 

Federal Income Taxes:    No provision has been made for federal income tax purposes since we qualify as a REIT under Sections 856 to 860 of the Internal Revenue Code of 1986, and intend to continue to remain so qualified. As such, we are exempt from federal income taxes and we are required to distribute at least 90% of our real estate investment taxable income to our shareholders.

 

We are subject to a federal excise tax computed on a calendar year basis. The excise tax equals 4% of the amount by which 85% of our ordinary income plus 95% of any capital gain income for the calendar year exceeds cash distributions during the calendar year, as defined. No provision for excise tax has been reflected in the financial statements as no tax is expected to be due.

 

Earnings and profits, which determine the taxability of dividends to shareholders, will differ from net income reported for financial reporting purposes due to the differences for federal tax purposes in the cost basis of assets and in the estimated useful lives used to compute depreciation and the recording of provision for investment losses.

 

Relationship with UHS and Related Party Transactions:    UHS is our principal tenant and through UHS of Delaware, Inc., a wholly owned subsidiary of UHS, serves as our advisor (the “Advisor”) under an Advisory Agreement dated December 24, 1986 between the Advisor and us (the “Advisory Agreement”). Our officers are all employees of a wholly-owned subsidiary of UHS and although as of December 31, 2014 we had no salaried employees, our officers do receive stock-based compensation.

 

Pursuant to the Advisory Agreement, the Advisor is obligated to present an investment program to us, to use its best efforts to obtain investments suitable for such program (although it is not obligated to present any particular investment opportunity to us), to provide administrative services to us and to conduct our day-to-day affairs. All transactions between us and UHS must be approved by the Trustees who are unaffiliated with UHS (the “Independent Trustees”). In performing its services under the Advisory Agreement, the Advisor may utilize independent professional services, including accounting, legal, tax and other services, for which the Advisor is reimbursed directly by us. The Advisory Agreement may be terminated for any reason upon sixty days written notice by us or the Advisor. The Advisory Agreement expires on December 31 of each year; however, it is renewable by us, subject to a determination by the Independent Trustees, that the Advisor’s performance has been satisfactory. Our advisory fee was 0.70% during each of 2014 and 2013, and 0.65% during 2012, of our

 

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average invested real estate assets, as derived from our consolidated balance sheet. In December of 2014, based upon a review of our advisory fee and other general and administrative expenses, as compared to an industry peer group, the Advisory Agreement was renewed for 2015 pursuant to the same terms as the Advisory Agreement in place during 2014 and 2013.

 

The combined revenues generated from the leases on the UHS hospital facilities comprised approximately 28% for the year ended December 31, 2014 and 30% for each of the years ended December 31, 2013 and 2012. The decrease during 2014, as compared to 2013, is due primarily to the 2014 purchase of the third-party minority ownership interests in eight LLCs in which we previously held noncontrolling majority ownership interests (we began recording the financial results of the entities in our financial statements on a consolidated basis at the effective dates). Including 100% of the revenues generated at the unconsolidated LLCs in which we have various non-controlling equity interests ranging from 33% to 95%, the leases on the UHS hospital facilities accounted for 22% of the combined consolidated and unconsolidated revenues for each of the years ended December 31, 2014 and 2013 and 21% of the combined consolidated and unconsolidated revenues for the year ended December 31, 2012. The hospital leases with subsidiaries of UHS are unconditionally guaranteed by UHS and are cross-defaulted with one another. In addition, including the two free-standing emergency departments (“FEDs”) acquired by us from subsidiaries of UHS during the first quarter of 2015, fifteen MOBs/FEDs, that are either wholly or jointly-owned, include tenants which are subsidiaries of UHS.

 

For additional disclosure related to our relationship with UHS, please refer to Note 2 to the consolidated financial statements—Relationship with UHS and Related Party Transactions.

 

Recent Accounting Pronouncements:    For a summary of recent accounting pronouncements, please see Note 1 to the Consolidated Financial Statements as included in this Annual Report on Form 10-K for the year ended December 31, 2014.

 

Results of Operations

 

Year ended December 31, 2014 as compared to the year ended December 31, 2013:

 

Effective August 1, 2014, we purchased the minority ownership interests, ranging from 5% to 15%, held by third-party members in six LLCs in which we previously held noncontrolling majority ownership interests. As a result of these minority ownership purchases, we now own 100% of each of these six LLCs and our Consolidated Statement of Income for the year ended December 31, 2014 includes the revenues and expenses associated with each of these properties for the five-month period ended December 31, 2014. Prior to August 1, 2014, these LLCs were accounted for on an unconsolidated basis pursuant to the equity method, as discussed above.

 

Effective January 1, 2014, we purchased the 5% minority ownership interests held by third-party members in Palmdale Medical Properties (“Palmdale”) and Sparks Medical Properties, two LLCs in which we previously held noncontrolling majority ownership interests. As a result of these minority ownership purchases, we now own 100% of each of these LLCs and our Consolidated Statement of Income for the year ended December 31, 2014 includes the revenues and expenses associated with each of these properties. Prior to January 1, 2014, these LLCs were accounted for on an unconsolidated basis pursuant to the equity method. Prior to our purchase of the minority ownership interest in Palmdale, and as a result of a master lease agreement with a wholly-owned subsidiary of UHS which expired on July 1, 2013, Palmdale was previously included in our financial statements on a consolidated basis during the period of January 1, 2013 through June 30, 2013, and on an unconsolidated basis during the period of July 1, 2013 through December 31, 2013.

 

The table below provides supplemental financial information related to each of the above-mentioned entities for the year ended December 31, 2013 and also presents 2013 on an “As Adjusted” financial statement presentation basis similar to the presentation applied for each entity for the year ended December 31, 2014. Other than the increased depreciation and amortization expense resulting from the amortization of the intangible assets recorded in connection with these transactions, there was no material impact to our net income as a result of the consolidation of these LLCs.

 

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Year Ended December 31, 2014 as compared to the Year Ended December 31, 2013:

 

     As reported in
Consolidated
Statements
of Income for
the Year
Ended
December 31,
2014
    As reported in
Consolidated
Statements
of Income for
the Year
Ended
December 31,
2013
    Year Ended
December 31,
2013
Statements
of Income
Adjustments
(a.)
    “As
Adjusted”
Year
Ended
December 31,
2013
    “As
Adjusted”
Variance
 

Revenues

   $ 59,786      $ 54,280      $ 4,184      $ 58,464      $ 1,322   

Expenses:

          

Depreciation and amortization

     20,885        18,753        1,044        19,797        (1,088 )

Advisory fees to UHS

     2,545        2,369        0        2,369        (176 )

Other operating expenses

     16,882        14,409        2,083        16,492        (390 )

Transaction costs

     427        203        0        203        (224 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     40,739        35,734        3,127        38,861        (1,878 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before equity in income of unconsolidated LLCs, interest expense and gains

     19,047        18,546        1,057        19,603        (556 )

Equity in income of unconsolidated LLCs

     2,428        2,095        (207 )     1,888        540   

Gains on fair value recognition resulting from purchase of minority interests in majority-owned LLCs

     25,409        0        0        0        25,409   

Gain on divestiture of real property

     13,043        0        0        0        13,043   

Interest expense, net

     (8,376 )     (7,472 )     (850 )     (8,322 )     (54 )
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 51,551      $ 13,169      $ 0      $ 13,169      $ 38,382   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(a.) Adjustments include: (i) revenue and expense impact for the five months ended December 31, 2013, for the six LLCs that we began consolidating effective August 1, 2014, as mentioned above, and; (ii) revenue and expense impact for the six months ended December 31, 2013 for Palmdale Medical Properties that we began consolidating effective January 1, 2014 (this LLC was accounted for on a consolidated basis for the first six months of 2013), and; (iii) revenue and expense impact for the year ended December 31, 2013 for Sparks Medical Properties that we began consolidating effective January 1, 2014.

 

During 2014, net income increased $38.4 million to $51.6 million as compared to $13.2 million during 2013. The increase was primarily attributable to the following, as computed utilizing the “As Adjusted” Variance column indicated on the table above:

 

   

an increase of $25.4 million from the aggregate gain recorded during 2014 on the fair value recognition resulting from purchase of minority interests in majority-owned LLCs, as discussed above;

 

   

an increase of $13.0 million from the gain recorded during 2014 on the divestiture of real property (The Bridgeway);

 

   

an increase of $347,000 in bonus rental earned on the hospital facilities leased to wholly-owned subsidiaries of UHS;

 

   

a decrease of approximately $1.1 million (As Adjusted) attributable to a net increase in depreciation and amortization expense, resulting primarily from the fair value recognition recorded in connection with our acquisition of minority ownership interests in eight LLCs in January and August, 2014;

 

   

a decrease of $224,000 resulting from the increase in transaction costs, and;

 

   

other combined net increase of approximately $895,000, including net income generated at properties acquired during 2014 and 2013.

 

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Total revenues increased by $1.3 million (As Adjusted) during 2014 as compared to 2013 primarily due to: (i) the revenues generated at MOBs acquired during 2014 and 2013; (ii) an increase in bonus rental revenue, as mentioned above, and; (iii) other combined net changes at existing properties.

 

Included in our other operating expenses are expenses related to the consolidated medical office buildings, which totaled $15.5 million and $14.8 million (“As Adjusted”) for 2014 and 2013, respectively. A large portion of the expenses associated with our consolidated medical office buildings is passed on directly to the tenants either directly as tenant reimbursements of common area maintenance expenses or included in base rental amounts. Tenant reimbursements for operating expenses are accrued as revenue in the same period the related expenses are incurred and are included as tenant reimbursement revenue in our consolidated statements of income.

 

During 2014, we had a total of 80 new or renewed leases related to the medical office buildings, in which we have significant investments, some of which are accounted for by the equity method. These leases comprised approximately 11% of the aggregate rentable square feet of these properties (6% related to renewed leases and 5% related to new leases). Rental rates, tenant improvement costs and rental concessions vary from property to property based upon factors such as, but not limited to, the current occutopancy and age of our buildings, local overall economic conditions, proximity to hospital campuses and the vacancy rates, rental rates and capacity of our competitors in the market. The weighted-average tenant improvement costs associated with these new or renewed leases was approximately $22 per square foot during 2014. The weighted-average leasing commissions on the new and renewed leases commencing during 2014 was approximately 2% of base rental revenue over the term of the leases. The average aggregate value of the tenant concessions, generally consisting of rent abatements, provided in connection with new and renewed leases commencing during 2014 was approximately 2% of the future aggregate base rental revenue over the lease terms. Rent abatements were, or will be, recognized in our results of operations under the straight-line method over the lease term regardless of when payments are due. In connection with lease renewals executed during 2014, the weighted-average rental rates, as compared to rental rates on the expired leases, decreased by approximately 1%.

 

Funds from operations (“FFO”) is a widely recognized measure of performance for Real Estate Investment Trusts (“REITs”). We believe that FFO and FFO per diluted share, and adjusted funds from operations (“AFFO”) and AFFO per diluted share, which are non-GAAP financial measures (“GAAP” is Generally Accepted Accounting Principles in the United States of America), are helpful to our investors as measures of our operating performance. We compute FFO, as reflected below, in accordance with standards established by the National Association of Real Estate Investment Trusts (“NAREIT”), which may not be comparable to FFO reported by other REITs that do not compute FFO in accordance with the NAREIT definition, or that interpret the NAREIT definition differently than we interpret the definition. AFFO was also computed for the years ended 2014 and 2013, as reflected below, since we believe it is helpful to our investors since it adjusts for the effect of the transaction costs related to acquisitions. FFO/AFFO do not represent cash generated from operating activities in accordance with GAAP and should not be considered to be an alternative to net income determined in accordance with GAAP. In addition, FFO/AFFO should not be used as: (i) an indication of our financial performance determined in accordance with GAAP; (ii) an alternative to cash flow from operating activities determined in accordance with GAAP; (iii) a measure of our liquidity, or; (iv) an indicator of funds available for our cash needs, including our ability to make cash distributions to shareholders.

 

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Below is a reconciliation of our reported net income to FFO and AFFO for 2014 and 2013 (in thousands):

 

     2014     2013  

Net income

   $ 51,551      $ 13,169   

Depreciation and amortization expense on real property/intangibles of consolidated investments

     20,548        18,496   

Depreciation and amortization expense on real property/intangibles of unconsolidated affiliates

     2,290        3,290   

Gains on fair value recognition resulting from the purchase of minority interests in majority-owned LLCs

     (25,409 )     —     

Gain on divestiture of real property

     (13,043 )     —     
  

 

 

   

 

 

 

Funds From Operations

     35,937        34,955   

Transaction costs

     427        203   
  

 

 

   

 

 

 

Adjusted Funds From Operations

   $ 36,364      $ 35,158   
  

 

 

   

 

 

 

 

Our FFO increased $1.0 million to $35.9 million during 2014 as compared to $35.0 million during 2013. The increase was primarily due to: (i) a favorable change of $38.4 million in net income, as discussed above; (ii) minus the $38.5 million of combined gains, as discussed above, plus; (iii) the favorable effect of the adding back increased depreciation expense incurred by us and our unconsolidated affiliates amounting to approximately $1.1 million. Our AFFO, which excludes transactions costs incurred during each year, were $36.4 million during 2014 as compared to $35.2 million during 2013.

 

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Year ended December 31, 2013 as compared to the year ended December 31, 2012:

 

Our Consolidated Statement of Income for the year ended December 31, 2012, includes the revenue and expenses associated with Palmdale Medical Properties, an LLC in which we held a 95% non-controlling equity interest as of December 31, 2013 (we now hold 100% of the ownership in this LLC effective as of January 1, 2014). As previously discussed, effective July 1, 2013, the master lease agreement between Palmdale Medical Properties and Palmdale Regional Medical Center, a wholly-owned subsidiary of UHS, expired. Therefore, effective on July 1, 2013, this LLC was no longer considered a variable interest entity and we began accounting for this LLC on an unconsolidated basis pursuant to the equity method. Prior to the expiration of the master lease, this LLC was accounted for on a consolidated basis, through June 30, 2013. The table below reflects the “As Adjusted” Statement of Income for the twelve months ended December 31, 2012, reflecting the revenue and expense impact of the deconsolidation of this LLC as if it had been deconsolidated effective July 1, 2012, since our Consolidated Statement of Income for the first six months of 2013 includes the revenue and expenses associated with Palmdale Medical Properties. There was no material impact to our net income as a result of the deconsolidation of this LLC.

 

    Year Ended December 31, 2013     Year Ended December 31, 2012        
    As reported
in
Consolidated
Statements
of Income
    As reported
in
Consolidated
Statements
of Income
    July 1 –
December 31,
2012
Statements
of Income
for
Palmdale
Medical
Properties
    “As
Adjusted”
    “As
Adjusted”
Variance
 

Revenues

  $ 54,280      $ 53,950      $ 657      $ 53,293      $ 987   

Expenses:

         

Depreciation and amortization

    18,753        20,216        172        20,044        1,291   

Advisory fees to UHS

    2,369        2,119        —          2,119        (250

Other operating expenses

    14,409        14,575        266        14,309        (100

Transaction costs

    203        680        —          680        477   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    35,734        37,590        438        37,152        1,418   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before equity in income of unconsolidated LLCs, interest expense and gains, net

    18,546        16,360        219        16,141        2,405   

Equity in income of unconsolidated LLCs

    2,095        2,365        (13     2,378        (283

Gains on divestiture of properties owned by unconsolidated LLCs

    —          8,520        —          8,520        (8,520

Interest expense, net

    (7,472     (7,768     (206     (7,562     90   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

  $ 13,169      $ 19,477      $ —       $ 19,477      ($ 6,308
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

During 2013, net income decreased $6.3 million to $13.2 million as compared to $19.5 million during 2012. The decrease was primarily attributable to the following, as computed utilizing the “As Adjusted” Variance column indicated on the table above:

 

   

an unfavorable change of $8.5 million resulting from the aggregate net gains recorded during 2012 on divestiture of properties owned by two unconsolidated LLCs in which we formerly held noncontrolling majority ownership interests, as discussed below and herein (see Note 3 to the Consolidated Financial Statements);

 

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a favorable change of $1.3 million (As Adjusted) resulting from a decrease in depreciation and amortization expense, resulting primarily from a $1.7 million decrease in amortization expense recorded on intangible assets, partially offset by an increase in depreciation expense resulting from MOBs acquired during 2013 and the fourth quarter of 2012;

 

   

a favorable change of $477,000 resulting from a decrease in transaction costs;

 

   

a favorable change of $90,000 (As Adjusted) in interest expense due primarily to a decrease in the average effective borrowing rate pursuant to the terms of our $150 million revolving credit agreement, partially offset by an increase in our average outstanding borrowings (as discussed below in Credit facilities and mortgage debt), and;

 

   

other combined net favorable changes of $354,000 including the aggregate net operating income (before depreciation and amortization and interest expense) generated at three MOBs acquired during 2013 and the fourth quarter of 2012, partially offset by the net operating losses incurred at a newly constructed MOB that opened in April, 2013 (property is owned by an unconsolidated LLC in which we hold a noncontrolling majority ownership interest).

 

Total revenues increased approximately $1.0 million (As Adjusted) during 2013, as compared to 2012, due primarily from increases resulting from MOBs acquired during 2013 and the fourth quarter of 2012, partially offset by other combined revenue decreases experienced at certain properties.

 

Included in our other operating expenses are expenses related to the consolidated medical office buildings, which totaled $12.9 million and $12.6 million (As Adjusted basis), for 2013 and 2012, respectively. The increase in other operating expenses during 2013, as compared to 2012, is primarily attributable to expenses related to the MOBs acquired during 2013 and the fourth quarter of 2012. A large portion of the expenses associated with our consolidated medical office buildings is passed on to the tenants either directly as tenant reimbursements of common area maintenance expenses or included in base rental amounts. Tenant reimbursements for operating expenses are accrued as revenue in the same period the related expenses are incurred and are included in tenant reimbursements and other revenue in our consolidated statements of income.

 

During 2013, we had a total of 106 new or renewed leases related to the medical office buildings indicated above, in which we have significant investments, some of which are accounted for by the equity method. These leases comprised approximately 13% of the aggregate rentable square feet of these properties (8% related to renewed leases and 5% related to new leases). Rental rates, tenant improvement costs and rental concessions vary from property to property based upon factors such as, but not limited to, the current occupancy and age of our buildings, local overall economic conditions, proximity to hospital campuses and the vacancy rates, rental rates and capacity of our competitors in the market. The weighted-average tenant improvement costs associated with these new or renewed leases was approximately $17 per square foot during 2013. The weighted-average leasing commissions on the new and renewed leases commencing during 2013 was approximately 3% of base rental revenue over the term of the leases. The average aggregate value of the tenant concessions, generally consisting of rent abatements, provided in connection with new and renewed leases commencing during 2013 was approximately 2% of the future aggregate base rental revenue over the lease terms. Rent abatements were, or will be, recognized in our results of operations under the straight-line method over the lease term regardless of when payments are due. In connection with lease renewals executed during 2013, the weighted-average rental rates, as compared to rental rates on the expired leases, decreased by approximately 6%.

 

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Below is a reconciliation of our reported net income to FFO and AFFO for 2013 and 2012 (in thousands):

 

     2013      2012  

Net income

   $ 13,169       $ 19,477   

Depreciation and amortization expense on real property/intangibles of consolidated investments

     18,496         20,030   

Depreciation and amortization expense on real property/intangibles of unconsolidated affiliates

     3,290         3,293   

Gains (net of related transaction costs) on divestiture of properties owned by unconsolidated LLCs

     —           (8,520
  

 

 

    

 

 

 

Funds From Operations

     34,955         34,280   

Transaction costs

     203         680   
  

 

 

    

 

 

 

Adjusted Funds From Operations

   $ 35,158       $ 34,960   
  

 

 

    

 

 

 

 

Our FFO increased $675,000 to $35.0 million during 2013 as compared to $34.3 million during 2012. The increase was primarily due to: (i) an unfavorable change of $6.3 million resulting from the decrease in net income, as discussed above; (ii) an unfavorable change of $1.5 million in the add-back of depreciation and amortization expense on real property/intangibles, and; (iii) a favorable change of $8.5 million in gains recorded on divestiture of properties owned by an unconsolidated LLCs. Our AFFO, which excludes transactions costs incurred during each year, were $35.2 million during 2013 as compared to $35.0 million during 2012.

 

Effects of Inflation

 

Inflation has not had a material impact on our results of operations over the last three years. However, since the healthcare industry is very labor intensive and salaries and benefits are subject to inflationary pressures, as are supply and other costs, we and the operators of our hospital facilities cannot predict the impact that future economic conditions may have on our/their ability to contain future expense increases. Depending on general economic and labor market conditions, the operators of our hospital facilities may experience unfavorable labor market conditions, including a shortage of nurses which may cause an increase in salaries, wages and benefits expense in excess of the inflation rate. Their ability to pass on increased costs associated with providing healthcare to Medicare and Medicaid patients is limited due to various federal, state and local laws which have been enacted that, in certain cases, limit their ability to increase prices. Therefore, there can be no assurance that these factors will not have a material adverse effect on the future results of operations of the operators of our facilities which may affect their ability to make lease payments to us.

 

Most of our leases contain provisions designed to mitigate the adverse impact of inflation. Our hospital leases require all building operating expenses, including maintenance, real estate taxes and other costs, to be paid by the lessee. In addition, certain of the hospital leases contain bonus rental provisions, which require the lessee to pay additional rent to us based on increases in the revenues of the facility over a base year amount. In addition, most of our MOB leases require the tenant to pay an allocable share of operating expenses, including common area maintenance costs, insurance and real estate taxes. These provisions may reduce our exposure to increases in operating costs resulting from inflation. To the extent that some leases do not contain such provisions, our future operating results may be adversely impacted by the effects of inflation.

 

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Liquidity and Capital Resources

 

Year ended December 31, 2014 as compared to December 31, 2013:

 

Net cash provided by operating activities

 

Net cash provided by operating activities was $32.8 million during 2014 as compared to $31.3 million during 2013. The $1.5 million increase was attributable to:

 

   

a favorable change of $2.2 million due to an increase in net income plus the adjustments to reconcile net income to net cash provided by operating activities (depreciation and amortization, amortization on debt premium, restricted stock-based compensation, gain on divestiture of real property and gains on purchases of minority interests in majority owned LLCs), as discussed above in Results of Operations;

 

   

an unfavorable change of $1.0 million in accrued expenses and other liabilities resulting primarily from the timing of accrued expenses and other liabilities disbursements;

 

   

an unfavorable change of $319,000 in tenant reserves, escrows, deposits and prepaid rents resulting primarily from a decrease in prepaid rents, and;

 

   

other combined net favorable changes of $646,000, including a favorable change in rent receivable of approximately $200,000.

 

Net cash used in investing activities

 

Net cash used in investing activities was $4.0 million during 2014 as compared to $13.4 million during 2013.

 

2014:

 

During 2014, we used $4.0 million of net cash in investing activities as follows:

 

   

spent $1.3 million to fund equity investments in unconsolidated LLCs;

 

   

spent $2.9 million on additions to real estate investments primarily for tenant improvements at various MOBs;

 

   

spent $15.6 million to acquire the real estate assets of three medical office buildings;

 

   

spent $4.7 million (plus a net note payable of $2.3 million to the previous third-party minority interest member, which was satisfied during January, 2015) to acquire the minority interests in eight majority-owned LLCs in two separate transactions effective August 1, 2014 and January 1, 2014, as previously discussed;

 

   

spent $100,000 consisting of a deposit on real estate assets related to the acquisition of a medical office buildings that we purchased during the first quarter of 2015;

 

   

received $17.3 million of cash proceeds in connection with the sale of The Bridgeway, as discussed above;

 

   

received $2.3 million of cash distribution proceeds in connection with refinancing of third-party debt by the LLC that owns the Texoma Medical Plaza in which we have a 95% non-controlling equity interest, and;

 

   

received $1.0 million of cash in excess of income related to our unconsolidated LLCs ($3.4 million of cash distributions received less $2.4 million of equity in income of unconsolidated LLCs);

 

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2013:

 

During 2013, we used $13.4 million of net cash in investing activities as follows:

 

   

spent $3.0 million to fund equity investments in unconsolidated LLCs;

 

   

spent $4.6 million in advances in the form of member loans to unconsolidated LLCs;

 

   

spent $3.4 million on additions to real estate investments primarily for tenant improvements at various MOBs;

 

   

spent $4.7 million to acquire the real estate assets of two medical office buildings;

 

   

spent $150,000 consisting of a deposit on real estate assets related to the acquisition of two medical office buildings that we purchased during the first quarter of 2014;

 

   

received $2.3 million of cash in excess of income related to our unconsolidated LLCs ($4.4 million of cash distributions received less $2.1 million of equity in income of unconsolidated LLCs), and;

 

   

received $114,000 in repayments of advances previously made to an unconsolidated LLC.

 

Net cash used in financing activities

 

Net cash used in financing activities was $29.8 million during 2014 as compared to $17.5 million during 2013.

 

The $29.8 million of net cash used in financing activities during 2014 consisted of: (i) generated $19.3 million of net cash from the issuance of shares of beneficial interest, $19.0 million of which related to our at-the-market equity issuance program (as discussed below) and approximately $250,000 of which was primarily related to our dividend reinvestment program; (ii) paid $32.7 million of dividends; (iii) paid $12.3 million on mortgage and other notes payable that are non-recourse to us (including the pay-off of the $9.1 million outstanding mortgage balance on the Summerlin Hospital Medical Office Building I utilizing borrowed funds under our revolving credit facility); (iv) paid $4.0 million net repayments on our revolving line of credit, and; (v) paid $94,000 as partial settlement of accrued dividend equivalent rights.

 

The $17.5 million of net cash used in financing activities during 2013 consisted of: (i) generated $12.0 million of additional net borrowings on our revolving line of credit; (ii) generated $11.2 million of proceeds related to a new mortgage note payable (refinance) that is non-recourse to us; (iii) generated $5.8 million of net cash from the issuance of shares of beneficial interest, $5.5 million of which related to our at-the-market equity issuance program (as discussed below) and approximately $250,000 of which was related to our dividend reinvestment program; (iv) paid $31.8 million of dividends; (v) paid $14.4 million on mortgage and other notes payable that are non-recourse to us (including the pay-off of a mortgage note payable that was refinanced during the first quarter of 2013, resulting in the above-mentioned $11.2 million of mortgage proceeds to us); (vi) paid $101,000 as partial settlement of accrued dividend equivalent rights, and; (vii) paid $95,000 of financing costs on mortgage and other notes payable.

 

During the fourth quarter of 2013, we commenced an at-the-market (“ATM”) equity issuance program, pursuant to the terms of which we may sell, from time-to-time, common shares of our beneficial interest up to an aggregate sales price of $50 million to or through Merrill Lynch, Pierce, Fenner and Smith, Incorporated (“Merrill Lynch”), as sales agent and/or principal.

 

Since inception of this program, we have issued 580,900 shares at an average price of $45.97 per share, which generated approximately $25.6 million of net cash proceeds or receivables (net of approximately $1.1 million, consisting of compensation of $667,000 to Merrill Lynch, as well as $391,000 of other various fees and expenses), as follows:

 

   

2014:    We issued 426,187 shares at an average price of $47.51 per share which generated approximately $19.5 million of net cash proceeds or receivables (net of approximately $700,000, consisting of compensation of $506,000 to Merrill Lynch, as well as $195,000 of other various fees and expenses), and;

 

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2013:    We issued 154,713 shares at an average price of $41.71 per share which generated approximately $6.1 million of net cash proceeds or receivables (net of $357,000, consisting of compensation of $161,000 to Merrill Lynch, as well as $196,000 of other various fees and expenses).

 

In connection with this ATM program, our consolidated balance sheet includes approximately $1.1 million at December 31, 2014, and $600,000 at December 31, 2013, of net proceeds due to us in connection with shares issued in late December 2014 and 2013. The net cash proceeds related to these shares was received by us in early January 2015, and early January, 2014, respectively. The net proceeds receivable were non-cash items, as presented on the Consolidated Statements of Cash Flows at December 31, 2014 and 2013.

 

Year ended December 31, 2013 as compared to December 31, 2012:

 

Net cash provided by operating activities

 

Net cash provided by operating activities was $31.3 million during 2013 as compared to $30.8 million during 2012. The $511,000 increase was attributable to:

 

   

a favorable change of $1.1 million due to an increase in net income plus the adjustments to reconcile net income to net cash provided by operating activities (depreciation and amortization, amortization on debt premium, restricted stock-based compensation and net gains on divestiture of properties owned by unconsolidated LLCs), as discussed above in Results of Operations;

 

   

a favorable change of $116,000 in rent receivable;

 

   

an unfavorable change of $191,000 in tenant reserves, escrows, deposits and prepaid rents, and;

 

   

other combined net unfavorable changes of $526,000, resulting primarily from an increase in leasing commissions paid during 2013, as compared to 2012.

 

Net cash used in investing activities

 

Net cash used in investing activities was $13.4 million during 2013 as compared to $8.6 million during 2012. The factors contributing to the $13.4 million of net cash used in investing activities during 2013 are detailed above.

 

2012:

 

During 2012, we used $8.6 million of net cash in investing activities as follows:

 

   

spent $3.0 million to fund equity investments in unconsolidated LLCs;

 

   

spent $8.0 million to fund an advance in the form of a member loan to an unconsolidated LLC that owned the Centinela Medical Building Complex to extinguish its third-party debt (this entity divested its property during the fourth quarter of 2012 and the member loan was repaid to us in full);

 

   

spent $4.0 million on additions to real estate investments primarily for tenant improvements at various MOBs;

 

   

spent $16.9 million (net of certain acquired liabilities, third-part debt and prepaid deposits) to acquire the real estate assets of two medical office buildings;

 

   

spent $711,000 on payments made in settlement of assumed liabilities related to the acquired properties;

 

   

received $8.6 million in repayments of advances previously provided to unconsolidated LLCs as follows:

 

   

$8.0 million from the LLC that owned the Centinela Medical Building in which we had a 90% non-controlling equity interest (this property was divested during the fourth quarter of 2012), and;

 

   

$600,000 from various other LLCs in which we own non-controlling equity interests.

 

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received $3.2 million of cash in excess of income related to our unconsolidated LLCs ($5.6 million of cash distributions received less $2.4 million of equity in income of unconsolidated LLCs);

 

   

received $12.2 million, net, of cash in connection with our share of the proceeds received from the divestiture of property owned by two unconsolidated LLCs, and;

 

   

received $100,000 of refunded real estate deposits.

 

Net cash used in financing activities

 

Net cash used in financing activities was $17.5 million during 2013 as compared to $30.8 million during 2012. The factors contributing to the $17.5 million of net cash used in financing activities during 2013 are detailed above.

 

The $30.8 million of net cash used in financing activities during 2012 consisted of: (i) generated $4.6 million from additional net borrowings on our revolving line of credit; (ii) generated $14.0 million of proceeds related to two mortgage notes payable that are non-recourse to us; (iii) generated $350,000 of net cash from the issuance of shares of beneficial interest; (iv) paid $31.2 million of dividends; (v) paid $18.1 million on mortgage and other notes payable that are non-recourse to us (including the pay-offs of two mortgage notes payable that were refinanced during the second and fourth quarters of 2012, resulting in the $14.0 million of proceeds, as mentioned above, as well as a $600,000 mortgage principal pay-down); (vi) paid $384,000 of financing costs on mortgage and other notes payable, and; (vii) paid $106,000 as partial settlement of accrued dividend equivalent rights.

 

Additional cash flow and dividends paid information for 2014, 2013 and 2012:

 

As indicated on our consolidated statements of cash flows, we generated net cash provided by operating activities of $32.8 million during 2014, $31.3 million during 2013 and $30.8 million during 2012. As also indicated on our statements of cash flows, noncash expenses such as depreciation and amortization expense, amortization on debt premium, restricted stock-based compensation expense and provision for asset impairment, as well as the gains recorded during 2014 and 2012, are the primary differences between our net income and net cash provided by operating activities for each year. In addition, as reflected in the cash flows from investing activities section, we received $1.0 million during 2014, $2.3 million during 2013 and $3.2 million during 2012, of cash distributions in excess of income from various unconsolidated LLCs which represents our share of the net cash flow distributions from these entities. These cash distributions in excess of income represent operating cash flows net of capital expenditures and debt repayments made by the LLCs.

 

We generated $33.8 million during 2014, $33.6 million during 2013 and $34.0 million during 2012 related to the operating activities of our properties recorded on a consolidated and an unconsolidated basis. We paid dividends of $32.7 million during 2014, $31.8 million during 2013 and $31.2 million during 2012. During 2014, the $33.8 million of net cash generated related to the operating activities of our properties exceeded the $32.7 million of dividends paid by approximately $1.1 million. During 2013, the $33.6 million of net cash generated related to the operating activities of our properties exceeded the $31.8 million of dividends paid by approximately $1.9 million. During 2012, the $34.0 million of net cash generated related to the operating activities of our properties exceeded the $31.2 million of dividends paid by approximately $2.8 million.

 

As indicated in the cash flows from investing activities and cash flows from financing activities sections of the statements of cash flows, there were various other sources and uses of cash during each of the last three years. Therefore, the funding source for our dividend payments is not wholly dependent on the operating cash flow generated by our properties in any given period. Rather, our dividends, as well as our capital reinvestments into our existing properties, acquisitions of real property and other investments are funded based upon the aggregate net cash inflows or outflows from all sources and uses of cash from the properties we own either in whole or through LLCs, as outlined above.

 

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In determining and monitoring our dividend level on a quarterly basis, our management and Board of Trustees consider many factors in determining the amount of dividends to be paid each period. These considerations primarily include: (i) the minimum required amount of dividends to be paid in order to maintain our REIT status; (ii) the current and projected operating results of our properties, including those jointly-owned in LLCs, and; (iii) our future capital commitments and debt repayments, including those of our jointly-owned LLCs. Based upon the information discussed above, as well as consideration of projections and forecasts of our future operating cash flows, management and the Board of Trustees have determined that our operating cash flows have been sufficient to fund our dividend payments. Future dividend levels will be determined based upon the factors outlined above with consideration given to our projected future results of operations.

 

Included in the various sources of cash were: (i) funds generated from the repayments of advances made from us to LLCs ($114,000 in 2013 and $8.6 million in 2012); (ii) cash distributions of refinancing proceeds from LLCs of $2.3 million in 2014; (iii) $17.3 million in 2014 of funds generated from the divestiture of real property; (iv) net borrowings on our revolving credit agreement ($12.0 million during 2013 and $4.6 million during 2012); and; (v) issuance of shares of beneficial interest ($19.3 million during 2014, $5.8 million during 2013 and $350,000 during 2012). In addition, during 2012, funds were generated from the divestiture of property owned by unconsolidated LLCs, our share of which was $12.2 million.

 

In addition to the dividends paid, the following were also included in the various uses of cash: (i) investments in LLCs ($1.3 million during 2014 and $3.0 million during each of 2013 and 2012); (ii) advances made to LLCs/third-party partners ($4.6 million during 2013 and $8.0 million during 2012); (iii) additions to real estate investments and acquisitions of real property ($2.9 million in 2014, $3.4 million in 2013 and $4.0 million in 2012); (iv) acquisitions of medical office buildings ($15.6 million in 2014, $4.7 million in 2013 and $16.9 million in 2012); (v) acquisition of minority interests in majority-owned LLCs ($4.7 million in 2014); (vi) net repayments on our revolving credit agreement ($4.0 million during 2014); (vii) net repayments of mortgage, construction, third-party partners and other loans payable of consolidated MOBs and LLCs, net of financing costs ($12.3 million during 2014, $3.3 million during 2013 and $4.5 million during 2012); (viii) partial settlement of dividend equivalent rights (approximately $100,000 during each of 2014, 2013 and 2012); (ix) deposits on real estate assets ($100,000 during 2014 and $150,000 during 2013), and; (x) payments of assumed liabilities on acquired properties ($711,000 in 2012).

 

We expect to finance all capital expenditures and acquisitions and pay dividends utilizing internally generated and additional funds. Additional funds may be obtained through: (i) the issuance of equity pursuant to our at-the-market (“ATM”) equity issuance program (which has $23.3 million of gross proceeds remaining for issuance as of December 31, 2014); (ii) borrowings under our $150 million revolving credit facility (which has $54.0 million of available borrowing capacity, net of outstanding borrowings and letters of credit, as of December 31, 2014); (iii) borrowings under or refinancing of existing third-party debt pursuant to mortgage loan agreements entered into by our LLCs, and/or; (iv) the issuance of other long-term debt.

 

We believe that our operating cash flows, cash and cash equivalents, available borrowing capacity under our revolving credit facility and equity issuance capacity pursuant to the terms of the ATM program, and access to the capital markets provide us with sufficient capital resources to fund our operating, investing and financing requirements for the next twelve months, including providing sufficient capital to allow us to make distributions necessary to enable us to continue to qualify as a REIT under Sections 856 to 860 of the Internal Revenue Code of 1986. In the event we need to access the capital markets or other sources of financing, there can be no assurance that we will be able to obtain financing on acceptable terms or within an acceptable time. Our inability to obtain financing on terms acceptable to us could have a material unfavorable impact on our results of operations, financial condition and liquidity.

 

Credit facilities and mortgage debt

 

In July, 2011, we entered into a $150 million revolving credit agreement (“Credit Agreement”) which is scheduled to expire on July 24, 2015. We are in the process of renegotiating our Credit Agreement and, although

 

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we can provide no assurance we will do so, we expect to complete a replacement credit facility by March 31, 2015. The Credit Agreement includes a $50 million sub limit for letters of credit and a $20 million sub limit for swingline/short-term loans. The Credit Agreement also provides an option to increase the total facility borrowing capacity by an additional $50 million, subject to lender agreement. Borrowings made pursuant to the Credit Agreement will bear interest, at our option, at one, two, three, or six month LIBOR plus an applicable margin ranging from 1.75% to 2.50% or at the Base Rate plus an applicable margin ranging from 0.75% to 1.50%. The Credit Agreement defines “Base Rate” as the greatest of: (a) the administrative agent’s prime rate; (b) the federal funds effective rate plus 0.50%, and; (c) one month LIBOR plus 1%. A fee of 0.30% to 0.50% will be charged on the unused portion of the commitment. The margins over LIBOR, Base Rate and the commitment fee are based upon our ratio of debt to total capital. At December 31, 2014, the applicable margin over the LIBOR rate was 2.00%, the margin over the Base Rate was 1.00%, and the commitment fee was 0.35%.

 

At December 31, 2014, we had $89.8 million of outstanding borrowings and $6.3 million of letters of credit outstanding against our Credit Agreement. We had $54.0 million of available borrowing capacity, net of the outstanding borrowings and letters of credit outstanding as of December 31, 2014. There are no compensating balance requirements. The average amounts outstanding under our Credit Agreement were $104.6 million in 2014, $86.3 million in 2013 and $75.4 million in 2012 with corresponding effective interest rates, including commitment fees, of 2.4% in 2014, 2.2% in 2013 and 2.4% in 2012. The carrying amount and fair value of borrowings outstanding pursuant to the Credit Agreement was $89.8 million at December 31, 2014.

 

Covenants relating to the Agreement require the maintenance of a minimum tangible net worth and specified financial ratios, limit our ability to incur additional debt, limit the aggregate amount of mortgage receivables and limit our ability to increase dividends in excess of 95% of cash available for distribution, unless additional distributions are required to comply with the applicable section of the Internal Revenue Code of 1986 and related regulations governing real estate investment trusts. We are in compliance with all of the covenants at December 31, 2014. We also believe that we would remain in compliance if the full amount of our commitment was borrowed.

 

The following table includes a summary of the required compliance ratios, giving effect to the covenants contained in the Credit Agreement (dollar amounts in thousands):

 

     Covenant     December 31,
2014
 

Tangible net worth

   $ 125,000      $ 181,458   

Debt to total capital

     < 55     30.0

Debt service coverage ratio

     >3.00x        25.4x   

Debt to cash flow ratio

     < 3.50x        1.29x   

 

We have sixteen mortgages, all of which are non-recourse to us, included on our consolidated balance sheet as of December 31, 2014, with a combined outstanding balance of $122.9 million (excluding net debt premium of $523,000 at December 31, 2014). The following table summarizes our outstanding mortgages at December 31, 2014 (amounts in thousands):

 

Facility Name

   Outstanding
Balance
(in thousands) (a)
     Interest
Rate
    Maturity
Date

Spring Valley Medical Office Building fixed rate mortgage loan (b.)

   $ 4,920         5.50   February, 2015

Desert Valley Medical Center floating rate mortgage loan (c.)

     3,861         3.41   October, 2015

Palmdale Medical Plaza fixed rate mortgage loan (c.)

     6,008         3.69   October, 2015

Summerlin Hospital Medical Office Building III floating rate mortgage loan

     11,025         3.41   December, 2016

Peace Health fixed rate mortgage loan

     21,248         5.64   April, 2017

Auburn Medical II floating rate mortgage loan

     7,183         2.90   April, 2017

Medical Center of Western Connecticut fixed rate mortgage loan

     4,785         6.00   June, 2017

 

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Facility Name

   Outstanding
Balance
(in thousands) (a)
     Interest
Rate
    Maturity
Date

Summerlin Hospital Medical Office Building II fixed rate mortgage loan

     11,729         5.50   October, 2017

Phoenix Children’s East Valley Care Center fixed rate mortgage loan

     6,485         5.88   December, 2017

Centennial Hills Medical Office Building floating rate mortgage loan

     10,642         3.41   January, 2018

Sparks Medical Building/Vista Medical Terrace floating rate mortgage loan

     4,479         3.41   February, 2018

Rosenberg Children’s Medical Plaza fixed rate mortgage loan

     8,479         4.85   May, 2018

Vibra Hospital of Corpus Christi fixed rate mortgage loan

     2,902         6.50   July, 2019

700 Shadow Lane and Goldring MOBs fixed rate mortgage loan

     6,601         4.54   June, 2022

BRB Medical Office Building fixed rate mortgage loan

     6,673         4.27   December, 2022

Tuscan Professional Building fixed rate mortgage loan

     5,862         5.56   June, 2025
  

 

 

      

Total

   $ 122,882        
  

 

 

      

 

(a.) Amortized principal payments are made on a monthly basis.
(b.) This loan was repaid in full on February 10, 2015, utilizing funds borrowed under our revolving credit facility.
(c.) We expect these loans, which have a maturity date in October, 2015, to be refinanced at the then current market interest rates or repaid utilizing funds borrowed under our revolving credit facility.

 

The mortgages are secured by the real property of the buildings as well as property leases and rents. The mortgages have a combined fair value of approximately $124.7 million as of December 31, 2014. Changes in market rates on our fixed rate debt impacts the fair value of debt, but it has no impact on interest incurred or cash flow.

 

Contractual Obligations:

 

The following table summarizes the schedule of maturities of our outstanding borrowing under our revolving credit facility (“Credit Agreement”), the outstanding mortgages applicable to our properties recorded on a consolidated basis and our other contractual obligations as of December 31, 2014 (amounts in thousands):

 

     Payments Due by Period (dollars in thousands)  

Debt and Contractual Obligation

   Total      Less than 1 Year      2-3 years      4-5 years      More than
5 years
 

Long-term non-recourse debt-fixed(a)(b)

   $ 85,692       $ 12,973       $ 45,421       $ 12,432       $ 14,866   

Long-term non-recourse debt-variable(a)(b)

     37,190         4,923         18,578         13,689         —     

Long-term debt-variable(c)

     89,750         89,750        —           —           —     

Estimated future interest payments on debt outstanding as of December 31, 2014(d)

     18,450         6,484         8,134         1,961         1,871   

Equity and debt financing commitments(e)

     2,639         2,639         —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 233,721       $ 116,769       $ 72,133       $ 28,082       $ 16,737   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(a) The mortgages are secured by the real property of the buildings as well as property leases and rents. Property-specific debt is detailed above.
(b) Consists of non-recourse debt with a fair value of approximately $124.7 million as of December 31, 2014. Changes in market rates on our fixed rate debt impacts the fair value of debt, but it has no impact on interest incurred or cash flow. Excludes $52.7 million of combined third-party debt outstanding as of December 31, 2014, that is non-recourse to us, at the unconsolidated LLCs in which we hold various non-controlling ownership interests (see Note 8 to the consolidated financial statements).
(c)

Consists of $89.8 million of borrowings outstanding as of December 31, 2014 under the terms of our $150 million Credit Agreement which matures on July 24, 2015. The amount outstanding approximates fair value

 

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as of December 31, 2014. We are in the process of renegotiating our Credit Agreement, and although we can provide no assurance we will do so, we expect to complete a replacement credit facility by March 31, 2015.

(d) Assumes that all debt outstanding as of December 31, 2014, including borrowings under the Credit Agreement, and the sixteen loans, which are non-recourse to us, remain outstanding until the stated maturity date of the debt agreements at the same interest rates which were in effect as of December 31, 2014. We have the right to repay borrowings under the Credit Agreement at any time during the terms of the agreement, without penalty. Interest payments are expected to be paid utilizing cash flows from operating activities or borrowings under our revolving Credit Agreement.
(e) As of December 31, 2014, we have equity investment and debt financing commitments remaining in connection with our investments in various unconsolidated LLCs. As of December 31, 2014, we had outstanding letters of credit which secured the majority of these equity and debt financing commitments. The $54.0 million of available borrowing capacity as of December 31, 2014, pursuant to the terms of our Credit Agreement, is net of the standby letters of credit outstanding at that time. Our remaining financing commitments related to our investments in unconsolidated LLCs are as follows (in thousands):

 

     Amount  

Grayson Properties

   $ 406   

FTX MOB Phase II

     1,076   

Arlington Medical Properties

     1,157   
  

 

 

 

Total

   $ 2,639   
  

 

 

 

 

Off Balance Sheet Arrangements

 

As of December 31, 2014, we are party to certain off balance sheet arrangements consisting of standby letters of credit and equity and debt financing commitments as detailed on the above “Contractual Obligations” table. Our outstanding letters of credit at December 31, 2014 totaled $6.3 million consisting of: (i) $2.1 million related to Centennial Hills Medical Properties; (ii) $1.3 million related to Palmdale Medical Properties; (iii) $1.3 million related to Banburry Medical Properties; (iv) $1.1 million related to FTX MOB Phase II, and; (v) $478,000 related to Arlington Medical Properties.

 

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

 

Market Risks Associated with Financial Instruments

 

As of December 31, 2014, 2013, and 2012, we had no material outstanding interest rate swap agreements.

 

During the third quarter of 2013, we entered into an interest rate cap on a total notional amount of $10 million whereby we paid a premium of $136,000. During the first quarter of 2014, we entered into two additional interest rate cap agreements on a total notional amount of $20 million whereby we paid premiums of $134,500. In exchange for the premium payments, the counterparties agreed to pay us the difference between 1.50% and one-month LIBOR if one-month LIBOR rises above 1.50% during the term of the cap. From inception through December 31, 2014, no payments have been made to us by the counterparties pursuant to the terms of these caps which expire on January 13, 2017.

 

The sensitivity analysis related to our fixed and variable rate debt assumes current market rates with all other variables held constant. The fair value of our debt is approximately $214 million. The difference between actual amounts outstanding and fair value is approximately $1.8 million.

 

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The table below presents information about our financial instruments that are sensitive to changes in interest rates, including debt obligations as of December 31, 2014. For debt obligations, the table presents principal cash flows and related weighted average interest rates by contractual maturity dates.

 

     Maturity Date, Year Ending December 31  

(Dollars in thousands)

   2015     2016     2017     2018     2019     Thereafter     Total  

Long-term debt:

          

Fixed rate:

          

Debt(a)

   $ 12,973      $ 2,154      $ 43,267      $ 8,969      $ 3,463      $ 14,866      $ 85,692   

Average interest rates

     5.3     5.4     5.2     5.1     5.0     4.8     5.1

Variable rate:

          

Debt(b)

   $ 94,673      $ 11,446      $ 7,132      $ 13,689      $ —       $ —       $ 126,940   

Average interest rates

     2.6     3.3     3.5     3.4     —         —         3.2

Interest rate caps:

          

Notional amount

   $ —       $ —       $ 30,000      $ —       $ —       $ —       $ 30,000   

Interest rates

         1.5        

 

(a) Consists of non-recourse mortgage notes payable.
(b) Includes $37.2 million of non-recourse mortgage notes payable and of $89.8 million of outstanding borrowings under the terms of our $150 million revolving credit agreement.

 

As calculated based upon our variable rate debt outstanding as of December 31, 2014 that is subject to interest rate fluctuations, each 1% change in interest rates would impact our net income by approximately $1.7 million.

 

ITEM 8. Financial Statements and Supplementary Data

 

Our Consolidated Balance Sheets, Consolidated Statements of Income, Changes in Equity and Cash Flows, together with the report of KPMG LLP, an independent registered public accounting firm, are included elsewhere herein. Reference is made to the “Index to Financial Statements and Schedule.”

 

ITEM 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

 

None.

 

ITEM 9A. Controls and Procedures

 

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

 

As of December 31, 2014, under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), we performed an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Securities and Exchange Act of 1934, as amended (the “1934 Act”). Based on this evaluation, the CEO and CFO have concluded that our disclosure controls and procedures are effective to ensure that material information is recorded, processed, summarized and reported by management on a timely basis in order to comply with our disclosure obligations under the Securities and Exchange Act of 1934 and the SEC rules thereunder.

 

Changes in Internal Control Over Financial Reporting

 

There have been no changes in our internal control over financial reporting or in other factors during the fourth quarter of 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Management’s Report on Internal Control Over Financial Reporting

 

Management is responsible for establishing and maintaining an adequate system of internal control over our financial reporting. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control—Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our system of internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation and fair presentation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness of internal control over financial reporting to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Based on its assessment, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2014, based on criteria in Internal Control—Integrated Framework (2013), issued by the COSO. The effectiveness of our internal control over financial reporting as of December 31, 2014 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which is included herein.

 

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Report of Independent Registered Public Accounting Firm

 

The Shareholders and Board of Trustees

Universal Health Realty Income Trust:

 

We have audited Universal Health Realty Income Trust’s internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Universal Health Realty Income Trust’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Universal Health Realty Income Trust maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Universal Health Realty Income Trust and subsidiaries as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the years in the three-year period ended December 31, 2014, and the financial statement schedule III, real estate and accumulated depreciation, and our report dated March 6, 2015 expressed an unqualified opinion on those consolidated financial statements and financial statement schedule III.

 

(signed) KPMG LLP

 

Philadelphia, Pennsylvania

March 6, 2015

 

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ITEM 9B. Other Information

 

None.

 

PART III

 

ITEM 10. Directors, Executive Officers and Corporate Governance

 

There is hereby incorporated by reference the information to appear under the captions “Proposal No. 1” (Election of Trustees), “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance” in our Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 2014. See also “Executive Officers of the Registrant” appearing in Item 1 hereof.

 

ITEM 11. Executive Compensation

 

There is hereby incorporated by reference information to appear under the caption “Executive Compensation” in our Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 2014.

 

ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

There is hereby incorporated by reference the information to appear under the caption “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 2014.

 

ITEM 13. Certain Relationships and Related Transactions, and Director Independence

 

There is hereby incorporated by reference the information to appear under the captions “Certain Relationships and Related Transactions” and “Corporate Governance” in our Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 2014.

 

ITEM 14. Principal Accounting Fees and Services

 

There is hereby incorporated herein by reference the information to appear under the caption “Relationship with Independent Registered Public Accounting Firm” in our Proxy Statement, to be filed with the Securities and Exchange Commission within 120 days after December 31, 2014.

 

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PART IV

 

ITEM 15. Exhibits, Financial Statement Schedules

 

(a) Documents filed as part of this report:

 

  (1) Financial Statements: See “Index to Financial Statements and Schedule”

 

  (2) Financial Statement Schedules: See “Index to Financial Statements and Schedule”

 

  (3) Exhibits:

 

3.1 Declaration of Trust, dated as of August 1986, previously filed as Exhibit 4.1 to the Trust’s Registration Statement on Form S-3 (File No. 333-60638) is incorporated herein by reference.

 

3.2 Amendment to Declaration of Trust, dated as of June 15, 1993, previously filed as Exhibit 4.2 to the Trust’s Registration Statement on Form S-3 (File No. 333-60638) is incorporated herein by reference.

 

3.3 Amended and restated bylaws previously filed as Exhibit 4.3 to the Trust’s registration statement on Form S-3 (File No. 333-60638) is incorporated herein by reference.

 

3.4 Amendment to the bylaws, effective as of September 6, 2013, previously filed as Exhibit 3.2 to the Trust’s Current Report on Form 8-K dated September 6, 2013, is incorporated herein by reference.

 

10.1 Advisory Agreement, dated as of December 24, 1986, between UHS of Delaware, Inc. and the Trust, previously filed as Exhibit 10.2 to the Trust’s Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference.

 

10.2 Agreement dated December 4, 2014, to renew Advisory Agreement dated as of December 24, 1986 between Universal Health Realty Income Trust and UHS of Delaware, Inc. is filed herewith.

 

10.3 Contract of Acquisition, dated as of August 1986, between the Trust and certain subsidiaries of Universal Health Services, Inc., previously filed as Exhibit 10.2 to Amendment No. 3 of the Registration Statement on Form S-11 and S-2 of Universal Health Services, Inc. and the Trust (File No. 33-7872), is incorporated herein by reference.

 

10.4 Form of Leases, including Form of Master Lease Document Leases, between certain subsidiaries of Universal Health Services, Inc. and the Trust, previously filed as Exhibit 10.3 to Amendment No. 3 of the Registration Statement on Form S-11 and Form S-2 of Universal Health Services, Inc. and the Trust (File No. 33-7872), is incorporated herein by reference.