Thank you all for joining. I would like to welcome you all to the Healthcare Realty Trust fourth quarter earnings conference call. My name is Brika, and I'll be your event specialist operating today's call. After the speaker's presentation today, we will conduct a question and answer session. If you wish to ask a question, please press press star followed by one on your telephone keypad. If you change your mind and would like to withdraw your question, please press star followed by two . For operator assistance at any point, it's star ten . Thank you. I would now like to hand the call over to our host, Ron Hubbard of investor relations. You may begin your conference, Ron.
Thank you, Brika. Thank you everyone for joining us today for Healthcare Realty's fourth quarter 2022 earnings conference call. Joining me on the call today are Todd Meredith, Kris Douglas, and Rob Hull. A reminder that except for the historical information contained within, the matters discussed in this call may contain forward-looking statements that involve estimates, assumptions, risks, and uncertainties. These risks are more specifically discussed in the company's Form 10-K filed with the SEC for the year ended December 31, 2022, and Form 10-Ks filed with the SEC for the quarters ended March 31, June 30, and September 30, 2022. These forward-looking statements represent the company's judgment as of the date of this call. The company disclaims any obligation to update this forward-looking material.
The matters discussed in this call may also contain certain non-GAAP measures, financial measures such as funds from operations or FFO, normalized FFO per share, normalized FFO per share, funds available for distribution or FAD, net operating income, NOI, EBITDA and adjusted EBITDA. A reconciliation of these measures to the most comparable GAAP financial measures may be found in the company's earnings press release for the quarter ended December 31, 2022. The company's earnings press release, supplemental information, and Form 10-Q are available on the company's website. I'll now turn the call over to Todd.
Thank you, Ron, thank you everyone for joining us for our fourth quarter of 2022 earnings call. I'll start by pointing out that we've successfully achieved two key merger integration objectives. First, in January, we completed the final portion of our planned asset sales to fund the merger-related special cash dividend. It's worth noting that we executed these sales at our targeted cap rates. Second, we realized our full annualized G&A savings in the fourth quarter. That's in half the time we originally expected. The primary driver was reaching our projected staffing levels. Most importantly, we've fully transitioned to the Healthcare Realty leasing model with full brokerage coverage across our portfolio. Later, Rob will expand on how this is already building leasing momentum. I would like to commend my Healthcare Realty colleagues for their incredible effort and dedication to accomplishing these milestones.
Looking to 2023, we expect to return to a steady state capital recycling mode. Given the current state of capital markets and the completed dispositions, we expect to optimize the portfolio at the edges. Proceeds will be reinvested primarily into our redevelopment pipeline. This is our top priority for 2023. We expect acquisitions to be modest, only selected properties that protect our market position and cluster strategy. With market scale and deep relationships, we are well prepared to ramp up accretive acquisitions when capital markets improve. The secured financing picture has improved notably since last November. This is important because secured financing drives nearly 2/3 of MOB buying power. Both underlying rates and spreads have improved. All-in rates improved more than 100 basis points from the peak last fall and now are about 50 basis points better. The breadth of lenders remains tight, but quality properties are getting financed.
Rates are now trending in the high fives. This improved financing has pulled MOB cap rates a bit lower since November toward the 6% level. MOB fundamentals remain favorable with robust demand for outpatient facilities. Healthcare is one of the largest, most stable, and fastest-growing employment sectors. Healthcare employment grew nearly 4% year-over-year in the most recent report, with ambulatory services growing even faster. These employees are coming to work every day in one of our buildings. We also see green shoots that inflation pressure and labor costs are easing, especially for health systems. We're talking to physician groups who are committing to more space today and health systems that are actively planning for more rapid outpatient growth in the near future. For the fourth quarter, we reported strong results in key operating metrics.
Same-store revenue grew well above 3%, propelled by healthy rent escalations, cash leasing spreads, and occupancy gains. Kris will get into more detail in a moment. In 2023, we expect same-store NOI growth to trend higher, above 3%, assuming moderating expense growth and steady occupancy gains. Leasing momentum is solid with over 600,000 sq ft of signed leases yet to take occupancies. This equates to roughly 150 basis points of gross absorption. We aim to capture most of this in the first half of 2023, boosting the current trend of 50 basis points of net absorption. Development starts are another clear sign of positive leasing demand. Healthcare Realty has the largest and most visible pipeline in the MOB sector. Our active pipeline is over $230 million, and our near-term prospective pipeline is roughly $350 million.
Behind this, we have a long-term embedded pipeline of $1.7 billion. This expanding pipeline is the benefit of the larger Healthcare Realty platform, deeper relationships, and significant market scale. We are in a leadership position to secure more development projects with major health systems. Looking ahead, Healthcare Realty's long-term outlook is bright. Our primary focus post-merger is operational execution to accelerate same-store NOI growth. With a well-scaled platform, we expect to capture outsized absorption and rent growth. We expect higher-yielding development projects to drive our external growth in the near term. As inflation moderates and interest rates stabilize, we'll add accretive acquisitions to bolster our growth profile. I'll turn it over to Kris to provide a review of our financial and operating results.
Thanks, Todd. We made tremendous progress on integration in the fourth quarter. Asset sales to fund the merger special dividend were completed. Our targeted annualized G&A savings was realized. Normalized FFO for 4Q was $0.42 per share, in line with the third quarter. The FFO results include normalization of $12 million in non-cash interest expense in both third and fourth quarter for merger-related fair value adjustments. We were encouraged by analysts and investors to normalize for this item to make results more comparable to peers. Normalized FFO in the quarter was impacted by a $5.2 million sequential increase in cash interest expense from higher rates on floating rate debt, as well as higher average debt balance. This was partially offset by a $4.5 million sequential reduction in G&A.
We have now realized $35 million of annualized cost reductions compared to pre-merger combined G&A. There are still some marginal synergies yet to be realized over the next two quarters, we expect these to be offset by normal G&A increases. $462 million of asset sales were completed since the end of the third quarter to finalize the full funding of the $1.1 billion merger special cash dividend. Run rate FFO, including the timing impact of the asset sales, is $0.41 per share. The run rate FFO and FAD shown on page five of the supplemental do not include any impact of additional changes in interest rates or growth in portfolio cash flow. Operating fundamentals were once again strong and highlight the growth potential of our properties. Same-store NOI for the year increased 2.5%.
Year-over-year quarterly same-store NOI growth was even higher at 2.7%. The contribution from the company's share of JVs improved both quarterly and annual growth by 10 basis points. The quarterly NOI growth was driven by a 3.3% increase in revenue, offset by a 4.6% increase in operating expenses. The year-over-year quarterly revenue growth was comprised of a 2.8% increase in revenue per occupied square foot and a 50 basis point improvement in average occupancy. We continue to focus on maximizing cash leasing spreads, occupancy, and in-place contractual increases. Cash leasing spreads in the quarter averaged 3.5%, up from 2.9% in the third quarter, with 80% of the leases having a spread of 3% or greater.
Sequential occupancy increased 59,000 sq ft or 10 basis points to 89.3% for the same-store properties. Total portfolio occupancy is 87.7%, providing meaningful opportunity for continued absorption and NOI growth. Annual contractual increases are now 2.81%, up from 2.64% last quarter. The improvement was the result of higher increases on leases with CPI-based escalators and 2.9% average future increases for the leases that commenced in the quarter. The improvement was also bolstered by the sale of our lower growth properties, which had annual escalators below 2.4%. Operating expense growth of 4.6% was down substantially from the 7.9% in the third quarter. We benefited in the quarter from several successful property tax appeals. Excluding their impact, expense growth is running approximately 6%.
Operating expense growth remains elevated compared to historical norms. Inflating pressures show signs of easing. This will allow the power of our revenue drivers and occupancy absorption to help drive improving NOI growth through 2023. Maintenance CapEx increased in the fourth quarter over the previous three quarters, which is consistent with the seasonality we typically experience. To give a better picture of capital expenditure trends, we provided on page five of the supplemental the combined company trailing 12-month maintenance CapEx spend. Based on the Healthcare Realty annual dividend of $1.24 per share, the pro forma 2022 FAD payout ratio was 94%. We expect the FAD payout ratio to be in the high 90s in 2023, given capital spending for expected occupancy absorption, as well as higher average interest rates year-over-year.
As interest rate increases moderate, the underlying fundamentals and growth of the portfolio will drive the payout ratio lower. Run rate pro forma debt-to-EBITDA at year-end, including the impact of January asset sales, was 6.4 x. Target leverage continues to be in the low to mid-sixes. We expect leverage to trend towards the lower end of this range from underlying portfolio growth. With minimal near-term funding needs, we will look to additional asset sales to fund limited acquisitions and steady development funding in 2023. Since the end of the third quarter, we have entered into $600 million of new interest rate swaps in anticipation of the $300 million of swaps that expired in late January. The net result is pro forma fixed-rate debt at approximately 85%, which is where we expect to remain for the near term.
As we wrap up 2022, we're pleased to have completed the funding of the merger special dividend, as well as achieved our targeted synergies ahead of schedule. In 2023, we are poised to unlock the operational benefits of our scaled and recession-resistant medical office portfolio. Now I'll turn it over to Rob for further updates on investment and leasing activity.
Thanks, Kris. With the completion of our merger-related sales, we expect additional dispositions of $200 million-$300 million this year. These sales will further optimize the portfolio's long-term growth expectations. Proceeds from our dispositions will fund our active development and redevelopment pipeline and a minimal amount of acquisitions like those we completed in the fourth quarter. Our primary focus for investing right now is development and redevelopment. For development, we target returns of 100-200 basis points above stabilized acquisition cap rates. Redevelopment is expected to produce richer returns in the 8%-11% range. In the fourth quarter, one new development advanced from our perspective to active pipeline. This 100% leased $25 million project is the first of a two-phase MOB development in Orlando.
This year, across our $235 million active pipeline, we expect to fund approximately $25 million-$30 million per quarter. We are seeing increased opportunities for developments through a greater market presence and a fresh start to newly inherited health system relationships. An example is in Phoenix, where we now own 35 buildings totaling 1.5 million sq ft. This market scale places us at the center of leasing activity and transaction deal flow. We are working on a joint venture opportunity with a reputable developer for a 100,000 sq ft MOB. The project of over $50 million is adjacent to a 120-bed hospital in an area undergoing explosive growth. The developer solicited our participation in the project, given our sizable presence in the market and our relationships with multiple health systems.
The development is 50% pre-leased with a clear path to 75% before construction begins. We added this project to our prospective development pipeline this quarter. Our much larger portfolio is a rich source for redevelopment opportunities. As an example, we are working on the redevelopment of two on-campus, 60% occupied MOBs in Houston that came to us from HTA. I recently traveled to meet with senior leadership to renew the relationship with the hospital. They shared plans to increase the hospital bed count by almost 50% with the addition of a new acute care bed tower. Our team shared a $20 million plan to redevelop our buildings. We all agreed that collaborating on these projects will reinvigorate the campus. The fresh start will attract physicians and create a great location to house new hospital services.
We expect to move this project to our active redevelopment pipeline later this year. Turning to leasing. During the quarter, we completed the onboarding of 100% of the legacy HTA portfolio to third-party brokers. Our brokers, combined with improving relationships with our new health system partners, will drive leasing momentum. What is really exciting is that we are already seeing early signs of improved leasing activity. A great example is prospective tenant tours. Across the portfolio, tours in January jumped 60% compared to the last three months of 2022. In a local example, our brokerage team in Phoenix recently used seven of their brokers to conduct 11 tours in one day. Such broad and efficient coverage is a testament to the value of a strong brokerage team.
In contrast, under HTA's in-house model, it would have been difficult to complete these tours in a week, allowing time to pass.
Interested parties to go elsewhere. Looking ahead, our Phoenix team is confident they can execute new leases in the next couple of months that will more than double our leased but not yet occupied space in this market. Similarly, I was recently talking to our Dallas-based director of leasing, who was energized by the momentum created from the brokers we added to our legacy HTA assets. He mentioned that the rate of monthly tours on one campus has doubled since adding them. More importantly, our brokers quickly sourced a sizable lease through their established provider net-network. With this momentum and leases currently in build-out, we expect gross absorption in this market to increase almost 350 basis points in the near term.
As we look to 2023, success on both the development and leasing fronts will serve as the foundation for accelerating growth. Operator, we are now ready to open the line for questions.
Thank you. As a reminder, if you'd like to ask a question, please press star then one on your telephone keypads now. If you do change your mind, please press star two. The first question we have comes from Austin Wurschmidt of KeyBanc . Your line is now open.
Hey. Hello, everybody. Just first question, kind of hitting a little bit on, you know, some of the strategic objectives looking forward. I mean, 2023 same-store NOI growth guidance of 3%-4%, has some implied acceleration from the fourth quarter and it's kind of consistent with what you've talked about. I'm curious what your latest thoughts are on the timeline of getting you into that high end of that 3%-5% same-store NOI growth opportunity that you guys have talked about following the merger. Is 2024, you know, a reasonable timeframe to think that you could, you know, could see that continue to accelerate? Thanks.
Thanks, Austin. Brica, if you don't mind, we're having a little bit of a quiet volume, so if you can add some volume for our end, that'd be great. Austin, for your question, I think just to clarify, our guidance for 2023 on same-store NOI growth is 2.5%-3.5%. Directionally, Austin, I think the point here, and I mentioned it in my remarks, that we're seeing a lot of strong trends in place, obviously on the revenue side through occupancy gains, rent growth, that are really pushing that revenue equation higher.
We see that translating in 2023 kind of throughout the year, from the lower end of that range, where we finished 2022, to sort of the higher end of the range through the balance of 2023. I think our view is we're heading north of 3% later in the year, and that certainly bodes well for the trend going into 2024, building off that momentum. I think, you know, again, 2.5%-3.5% for the year, but sort of a build in that range throughout the year.
Yeah, sorry about that. I was looking at the cash leasing spreads.
Yeah. That's certainly an important driver of it and a big contributor.
Yeah. Along similar lines, you know, you've talked about, you know, the upside from driving occupancy. You noted some of the, you know, SNO pipeline that you've got today, with, you know, a significant portion of that opportunity across HCA. How did you embed some of that, you know, some of those upside, some of that upside and drivers within the same-store NOI guidance? What are some of those puts and takes, I guess, that's, you know, that we should think about any near-term headwinds that are, you know, offsetting some of these benefits today as that starts to build over time?
Yeah. No, I think you can kind of see what we're trying to guide through with the different components of the same store. We are expecting to get some absorption as well as some improvement in our cash leasing spreads versus what we saw in 2022 as we bring, you know, the combination of the two companies together. You know, one piece that is, it's a bit of a headwind compared to, you know, historical experience, but an improving picture from where we've been in 2022 are our operating expenses. You know, as I talked about, you know, operating expenses are now for us running around 6%. You know, that's still elevated from our typical norm of 2% - 2.5%.
We are seeing some signs that that could start moving in the right direction. We don't anticipate that we'll get all the way back to that, you know, 2% - 2.5% in 2023. We think it hopefully will start moving in the right direction, which will allow those different components of the revenue drivers to shine through and drop to the bottom line on NOI growth.
Great. Thanks for the time.
Thank you. The next question comes from Nick Yulico of Scotiabank.
Great. Thanks. First question is just in terms of, you know, interest expense, I know you didn't give guidance on it specifically, but I wanted to just see if you know, if there's any way we can get a feel roughly for how, you know, I guess, cash interest expense without the mark-to-market on the debt, could look like this year.
Yeah, you know, it really kind of depends on exactly how much overall interest rates move across the year. To kind of give you a bit of kind of a heuristic, so to speak, on it, is that with about $900 million of floating rate debt right now, a 1% change in the annual interest rate ends up being about $0.015, you know, to overall growth on a per share amount for the year. That gives you a little bit of, you know, of the magnitude of the impact. We'll have to kind of continue to watch that through the balance of 2023.
Okay, that's helpful. Thanks. I guess just my follow-up question was, you know, on interest expense, I mean, I know you guys are, you know, excluding that merger fair value adjustment because it's non-cash from your normalized FFO. I know you were considering doing that because it's a large, you know, impact that you're having. You know, at the same time, other REITs aren't doing that. Granted, you know, other REITs don't have as big of an issue that you're facing. Just want to hear a little bit more about, you know, the decision to, you know, to remove that from your or the rationale to remove that from your normalized FFO calculation. Thanks, Kris.
You know, we did consider that and look at that. I think you're right, when you look at the impact that it has on us compared to peers and what's going on, you know, right now with the rapid change in interest rates, it is different. You know, we ended up with, you know, almost half of our balance sheet being marked to market, which resulted in over 20% of our income statement interest expense being non-cash related to this fair value adjustment. You know, we had several of our analysts, really we spoke to all of our analysts on this as well as a lot of our investors.
The consensus was that given the size and the unusual nature of that, it was going to create a lot of comparability issues. The recommendation is that we make this normalizing adjustment that we pointed out. I will, you know, remind you know, being non-cash, this is an FFO item. It's not a FAD item. That was the thought process that went into that decision.
Thanks. Appreciate the thought. Yeah.
Nick, I would just add that, yeah, clearly, you know, it was more material because of the merger, you know, and just the fact that we were buying HTA and therefore, you know, 60%, you know, larger balance sheet, or portion of the combined balance sheet, that's a huge amount, as Kris said. We don't have any real maturities, significant maturities until 2025. Like everyone, as we refinance in the future, we'll deal with the cash change like everyone in real time, but we're in really good position on that. Feel very good about the balance sheet, and it helps comparability, as Kris said.
Thanks, Todd.
Thank you. We now have Rich Anderson of SMBC. Your line is now open.
Thanks. Good morning. On the dividend, you said, you know, high 90s type of FAD payout. Let me close this. Hear me okay?
Yes. Go ahead.
Okay. Sorry about that. Had some feedback. You know, Kris, you mentioned the sensitivity to higher interest rates and what that does to, you know, the bottom line. Let's say it's not high 90s, but it's, you know, in triple digits in 2023 for whatever reason, to what degree are you willing to live with that and for what amount of time? Do you feel like you have enough visibility, or is a dividend cut, you know, at least being thought about at this point, based on where you stand today and all the moving parts?
Sure. Thanks, Rich. fair question. We're all wanting to be able to answer Nick's question about where interest rate's going?
Right.
Like everyone, we're using heuristics and just trying to manage appropriately. I think the short answer is we are confident that the operational improvements we're seeing that will read through are very strong and near term, and we think those can go a great deal to offset, you know, what might be hopefully short-term rising interest rates. Like everybody looking at forward curves, you know, seeing, you know, not if but when the rates start to come down. We feel very good about that momentum. Even if, as you just said, we found ourselves, you know, right at triple digits, I think we're very comfortable that the operational improvements are real and near term, you know, in 2023 but also in 2024. We feel very comfortable that should drive down fairly quickly just through operational improvements.
We do not at this point, you know, anticipate any notion of any cut. Obviously, we're all, you know, watching the markets and looking at the extent of this. That's something we reevaluate as a board and as a management team, you know, every quarter, every year. For now, that's our outlook, is that we feel very comfortable with where it's at.
One thing I might add to that, Rich, is that, you know, one of the things that is putting some pressure there has to do with the capital for the absorption that we're seeing across the portfolio. That's a good problem to have. That we look at that as growth capital that will enhance, you know, long-term cash flow and value. That's something that, you know, if you're dealing with that in the short term, that doesn't point to a long-term dividend issue.
maybe, I don't know if this is an obvious question, but if your FAD was 80% of payout, would you have bothered doing the swaps at this point? Was the tail wagging the dog there in terms of, you know, $600 million in swaps recently at this level in today's market?
Yeah. Yeah. No, I mean, if you really look at historically, the way we've handled our floating rate exposure is that we've tried to take a pretty neutral view on rates by swapping about 50%. That's where we ended up with the changes that we had with the $600 million of new and the $300 million that's expiring. It's still trying to take a balanced view on where rates are right now.
Okay. Then I just have a kind of weird question. You know, live dangerously, it's very last moment reporting. What had to get done in your mind that caused you to be so late in the reporting season? Is it, you know, obviously merger related, but is there anything specific you can point to, or was Todd just taking his kids to Disney World, so you guys just weren't available? What, you know, what was the reason for that?
That's a fair point. You know, we're trying to have a little more normalized post-merger frenzy. No, I think, Rich, for us, it was really. I mean, this was not a change we made recently. We anticipated that and put that out well ahead. That was kind of just the plan that said, "Hey, let's give ourselves, you know, really the maximum amount of time given the lift post-merger and, you know, the 10-K and audit, you know, first full audit post-merger." Easy for me to say, but I think we could have certainly managed an earlier timeframe, but we were just trying to give ourselves the benefit of the doubt. I think you'll see us kind of return to a more normal schedule throughout the year.
I wouldn't expect that, you know, this trend continues.
Okay. Sounds good. Thanks, guys.
Yes.
Thank you. We now have Michael Griffin of Citi. You may proceed.
Great. Thanks. Maybe not to harp too much on the interest expense side of the equation, but just from that run rate number, that $0.41 you gave heading into 2023, I just want to clarify, does that include the effects of the swap burnoffs from January? I know you talked about the interest rate sensitivity scenario, but, you know, what impact potentially the shares could obtain of that swap burning off from an interest expense perspective?
Yeah. No, it doesn't, because that was, that was a, you know, 12/31 run rate number where that swap expiration occurred in late January. That swap expiring and kind of converting to what our new swap rate is it ends up being about a little under $0.005 per share per quarter impact related to that expiration.
Gotcha. That's some helpful clarification. Then just on the targeted dispositions and guidance, you know, I'm curious, obviously, the expectation for the beginning of the year is probably a more muted capital markets environment, but just any sense of a buyer pool or pricing expectations? I did want to clarify, are any of these related to that $500 million of incremental dispositions you had initially targeted with the merger? You know, are they legacy assets? Is there, you know, maybe they're lower performing assets, tougher to lease, but any clarity around that would be helpful.
Yeah. I think, if you look at, you know, we've finished the merger-related dispositions, and we now are looking ahead. I think, you know, the way we think about the $200 million-$300 million is continued in pruning of the portfolio, really taking a look at properties that where we see an opportunity to get out of them. They don't. Maybe they're not in a cluster that we think that we can build up over time or a market that we think we can build up a time for. The expectations for growth are lower than what we're looking for.
I think in terms of what's in there and what we're expecting to sell, it's really trying to optimize the portfolio going forward and looking at getting out of possibly some smaller markets that we don't wanna be in long term. As far as pricing, I mean, I think right now, you know, we've seen some swings in interest rates over the past couple of quarters. I think we've seen, you know, the debt market's really driving pricing on MOBs. If you go back to the fall, debt costs were, you know, had gone up, you know, to the mid- to high sixes , probably.
We've seen about 100 basis points swing back down, then now probably from there, about another 50 basis points up. We think that's driving the cap rates. Right now we're sort of looking at, you know, cap rates that are moving towards around 6%. I think that's. For us and what we're trying to sell, we're sort of looking at that as the baseline. Certainly, properties that we're targeting for sale, you know, could be above that, could be below that. It just depends on what the asset is and the appetite out there.
All right. That's it for me. Thanks for the time.
Thank you. We now have Steven of Barclays. Your line is open.
Hi. Thanks. It's, yeah, Steve Valiquette from Barclays. Yeah, all the questions I think around both the, you know, the market for acquisitions and investors are kind of covered at this point. Maybe just to shift topics a little bit. The just on the same-store operating expenses, I think there was some improvement there a little bit. Anything worth calling out as far as just areas where you're seeing, you know, better ability to control costs, et cetera? I just want to hear more about kind of the trends there would be helpful. Thanks.
Yeah, I mentioned a little bit in my prepared remarks about the improvement that we did see in the fourth quarter compared to the third quarter . A good portion of that related to some successful property tax appeals. You know, excluding those property tax appeals, we're we see our operating expenses right around 6%, which is, you know, still trending down from what we were seeing earlier in the year. The good news, we're also seeing some signs that, as we move into 2023, we could see some continued improvement. A lot of that comes from the utility side. You know, that's one of our largest expenses. It's kind of over 20% of our operating expenses are related to utilities.
You know, those were, you know, utility expenses just on the rate side were up double digit in 2022 over 2021. You know, as you look at the forecast moving into 2023, you see that moderating. You know, we've even seen some forecasts that show it declining. I'm not ready to latch on to that, but if you can just start to see that, you know, come down a bit from what we saw in 2022, that gives a lot of line of sight to feel much better about where overall operating expenses should trend throughout 2023.
Okay, got it. Okay, that's helpful. Thanks.
Thank you. We now have Jonathan Hughes of Raymond James. Please go ahead when you're ready.
Hey, good afternoon. I just wanted to go back a little bit in time. I guess can we talk about how much of the decline between the kind of FAD figure we had talked about last summer of like, you know, $1.45 this year and the $1.24 annualized, you know, run rate FAD. How much of that decline is not from the higher interest rate backdrop? I'm just trying to understand where some of this, you know, the operational upside that was embedded in those projections has gone, and maybe if that's just simply delayed rather than no longer achievable.
Jonathan, I think one, the projections you're referring to clearly were, you know, in a very different environment. I think everybody's dealing with the interest rates to differing degrees. I don't think there's any change in the operational picture whatsoever. There's been no, you know, material delay or decline in the opportunity. In fact, I think we're seeing, you know, very strong signs. As Rob Hull walked through some specific examples, I talked about what we're seeing come through on same store. We're really not seeing anything that is operationally negative. I think, you know, this environment for a lot of folks, you know, has 2 big impacts. You've got your operating fundamental business, how's it doing, how's demand, what are the trends? You know, what everybody's dealing with is a dramatic sea-level change in interest rates.
You know, unless you just were, you know, prescient, perfectly prescient, and maybe lucky, you know, the interest rate side is what it is. We're all managing through it the ways we can, and I think we're in very good shape there. You know, certainly see a large impact, but see a rebound as things moderate coming from that side as well. Again, that's kind of what informs our swap position, you know, fixing those rates. I think operationally, we're very optimistic and bullish about where we're headed. I think, you know, Kris, unless you have something to add, I think it's the majority of that would be the interest rate environment is the impact there.
Yeah. We do still, and to the space you said, to be able to achieve on the operational, you know, upside. We're, you know, that's kind of what we're pointing to now is being able to have achieved the funding of the dividend, you know, special cash dividend as well as the synergies. Those were kind of two of what I would say are the three main pieces that we knew we needed to execute on. Third being kind of the operational upside, and that's what Rob was hitting on, that we're, we've kind of set that foundation, and we're seeing, you know, good indications to be able to start achieving that as we move through 2023 and, you know, into 2024.
That's helpful. I guess maybe on the operational side then, is there, is there some expected vacancy in the portfolio that's maybe preventing absorption from running a little higher? I think, you know, the midpoint is what? 60 basis points. I think it was 50 basis points of absorption last year. I'm just trying to, you know. It is improving. I'm just trying to square, you know, some of the bullish comments for the strength of the outpatient business, you know, that you mentioned earlier with just that, you know, what I would have thought maybe was more absorption upside.
Yeah. One comment there on the guidance is that that is, you know, overall same store, so that's multi-tenant and single tenant. We are, you know, you're somewhat diluted by the fact that your single tenant tends to run, you know, closer to 100% occupancy, and you don't expect a lot of changes. It gets a little diluted by that if you look at the ratio. It's really a more bullish sentiment on just multi-tenant, which is where the opportunity lies. I think to your point, you know, there's a little more than what I would call, you know, 40-80 basis points as our guide is for the total behind the multi-tenant. You know, more 50-100+ basis points.
The only other comment though that I would add is that, you know, we're very bullish. We see a lot of early signs. We're getting the leasing momentum underway. you know, it takes. There's a process for build-out. You know, we've got this pent-up 600,000 sq ft plus of occupied but not yet or excuse me, leased but not yet occupied. Building that up over time, you know, takes a little time, and then it might take, you know, 6 months plus.
Build out the space, convert it to occupancy. It does take a little time to deliver it, but obviously we're seeing the right trends in place to really see that coming through in the second half and certainly moving into 2024.
All right. Thank you. Just one more for me, just back on the kind of run rate FAD and dividend coverage, and you answered most of it with, you know, the prior questions. I don't think, Eric, can you just remind us of what's the target payout ratio? Kris, I think you said it hits kind of high 90s this year, but, you know, where can we expect that over the longer term? Thanks.
Yeah, I would say we would continue to drive that lower. You actually have seen that in our history. You know, we were at a point in time going back, you know, eight, 10 years ago, we were over 100%. Through the improvement in the portfolio and growth, we were able to drive that down into the, you know, mid-to-high 80s. Our expectation from there was to continue to drive it to drive it lower. That was before some of these, you know, interest expense pressures and things that we've talked about.
You know, long term, our goal is to continue to drive that lower, with at the same time being able to provide, you know, some growth in the, in the underlying dividend.
Yeah. I think in simple terms, you know, below 90 is certainly directionally where we wanna get back to. You know, we're obviously navigating the current environment and, you know, certainly wanna see it go into the 80s in the not too distant future.
All right. Thank you.
Thank you. We now have Michael Mueller of JPMorgan. Your line is open.
Yeah. Hi. Thanks. Kris, I think you talked about some of the swaps not being in the $0.41 run rate. When you layer everything into it, you know, the full impact of the swaps, and then, you know, looking at what you're expecting for acquisitions, dispositions, do you think you'll end the year with a run rate that's similar, higher or lower to that $0.41 now?
Yeah. As we start looking at the end of 2023, you know, it does come a bit, once again, back to interest rates. We, you know, as I mentioned, you know, the $0.41 doesn't have any expectation of changes in interest rates, but it also doesn't have any growth in the underlying portfolio, which is meaningful. Our expectation as we get to the end of the year that we should be able to outpace, you know, the pressures on interest rates that would have us ending 2023 in a higher, better run rate position than we're entering the year.
Got it. Even with net dispositions?
Yes, because we're looking at those dispositions to fund, you know, some marginal acquisitions as well as our development.
Got it. On the development, it looks like you have about $350 million of starts slated for the second half of the year. I mean, how should we think about as you move into 2024 and 2025 in terms of starts, annual starts?
Yeah. I think, if you look at, if you look at our prospective pipeline, right, it's about $350 million. There's about $200 million of that we've slated to expect to start at second half of this year. If you, if you combine that with the existing pipeline of $235 million, there will be some of those that are rolling off. We think that going into 2024, we could have, you know, six new starts towards the end of this year, first of next year, roughly $200 million. That would equate to a funding run rate of, you know, moving from $25 million-$30 million per quarter this year, up to about $50 million per quarter next year.
We're optimistic on those projects and pushing them forward and having great dialogue with all of the prospective tenants and health system partners.
Got it. Okay. Thank you.
Thank you. We now have Tayo Okusanya from Credit Suisse.
Yes. Good afternoon, everyone. Kris, your response to Michael was helpful to kind of talk through how the FFO run rate will build up in 2023. When I apply that same logic to kind of how FAD should build up in 2023, does it not imply that at some point, though, you do end up meaningfully, you know, at kind of a dividend coverage above 100%, especially kind of given, you are at 100% in 4Q? There's a dividend impact from a full year of asset sales. There's probably still rate pressure going forward. You have forecasted a decent amount of recurring CapEx, you know, TI leasing commissions as you kind of lease up the portfolio.
I'm just trying to think through that as well, in the context of Rich's earlier question about dividend policy.
Yeah. As we're looking at it, I think the same fundamentals that we're talking about being able to drive, you know, improvement and overall growth of the operations that we're seeing, that will flow through to FAD as well. You know, as I've said in my prepared remarks, you know, is the expectation, you know, for the year will probably be in that high 90s% on the payout ratio. As Rich said, you know, does that in any particular quarter because you know, the CapEx spend is not as smooth as earnings are.
You are gonna have some variation in any quarter. Could you be over 100% for some period of time? Yes, that's possible. As Todd kind of pointed to, we don't see that as concerning, especially if that is being driven by additional capital spend for absorption, which is really growth capital.
Mm-hmm.
You know, ± any one quarter, depending on how you're running your models, that would not be surprising. We still feel like, you know, long term directionally with what we're seeing in terms of internal growth, that we'll be able to, you know, balance out this year as well as drive that payout ratio lower, you know, in the future.
Got you. On that high nineties number, just for clarification, is that an average for 2023 or that's a year-end target?
That really is an average. I think the one key piece of helpful information we put in our earnings release, and I think it's worth a look, it's page 5 of the supplemental, is really looking at that seasonality on capital spend. Clearly we see a pattern year to year that fourth quarter is always high. If you look at fourth quarter, your payout ratio might be high, but if you average it throughout the year, we tend to be a little lower in the first half and it builds in the second half. That was true pre-merger, and we expect it to be true post-merger. You really have to look at the balance of the year. You can't really extrapolate off a fourth quarter purely on a payout ratio.
You really have to look at the full year, which is why we provide that additional disclosure.
Gotcha. One more, if you would indulge me. You're starting to get a lot more information from healthcare systems right now. Again, their bottom line is also under pressure. We are hearing about them again starting to, you know, consolidate MOBs, consolidate their regular admin space as they kind of try to improve their bottom line. Could you just kind of talk to me about what you're hearing from them as well and what potential impact that could have on not just demand, but even potentially ability to drive pricing going forward?
Sure. Yeah, I think 2022 is a pretty challenging year, you know, for everybody saw the interest rate side of the world change dramatically. I think in healthcare, you know, it was particularly challenging on the labor front, as we all know. I think if you look monthly trends throughout 2022, there's a dramatic difference in the first half to the second half. By the end of the year, that was starting to be, you know, much improved. I think that's obviously a bright spot going into 2023. You know, with moderating COVID impacts, as well as better labor costs, I think that's a much better environment. I think like everyone, they're grappling with, you know, the interest expense side of the world.
We're seeing some easing there, just like we talked about earlier on inflation, which is really encouraging. I think the real takeaway is that there's always rationalization going on by health systems of their space usage. I think the overwhelming trend you're seeing is a continued focus on how do we shift more to the outpatient setting where it is lower cost, more effective. I would say everything that we're seeing on the leasing side, everything on the development side underscores that there's just sort of a renewed energy to say that. That is really the picture of how we continue to drive our cost structure lower, our revenue models, our margins better. I think really outpatient continues to be part of the solution.
Doesn't mean they're not gonna always be trying to rationalize where they, you know, put their care and get it optimized. I think we're really poised to capture a lot of that incremental demand.
Great. Thank you.
Thanks, Todd.
Thank you. Thank you. We now have John Pawlowski of Green Street. Please go ahead when you're ready.
Thanks. I have a follow-up question on the occupancy upside and the multi-tenant square footage you guys outlined on page 16. Can you just give us a sense when you think you'll be able to get to 90%?
The 90%. This is something we've certainly talked about, you know, through the merger, through, you know, investor presentation. We've outlined some upside in NOI dollars in getting to 90% just for context. I think for us, you know, it's early stages. As Jonathan Hughes just asked, you know, sort of what does 2023 look like? Where is that occupancy upside? I talked about 150 basis points of gross absorption that we're really optimistic about in the early part of 2023. On a net basis, you know, we see that trend right now at 50 basis points of upside, but building towards the 100 level throughout the year. Our guidance is kind of for the average for the year.
It's, you know, obviously the implication of that would be, oh, you're sort of in the multi-tenant side, 85 going to 100 or going to 90. Is that, you know, does that mean it's 10 years worth? The short answer is no, we don't think it's that long. We think it's the early stages of building that momentum. It's a multi-year process. We can't say exactly what it is, but we'll keep building, you know, that execution year to year. I think it's, you know, we sort of think of it as a three, four-year timeframe, but we've obviously got to sort of put some successes here under our belt to really point to a more specific timeframe.
Okay, understood. Kris, the $10.8 million in merger-related costs in the quarter, what additional costs-.
Are left to incur. Are there any other just integration risks that are still looming in your minds?
To your second question, no big integration risks that we see. We do still have some work to be done. We're still working through combining our, you know, some of our systems, our accounting system. Fortunately, we're on the same system but on different versions. We're bringing those together. We do have some consultants that are helping us through that process. That's one of the merger-related costs that you will still see in the first quarter and probably there'll still be some, you know, moving into the second quarter. You know, a lot of that work is done, but yes, there is still some to be finalized.
Okay. Can you quantify the cost that will be incurred in 2023?
I don't have it right at my fingertips, but it will certainly be coming down from $10 million, you know, I think in the quarter. You know, it's gonna be less than $20 million.
Last question for me. Can you just give some context on what drove the decline in the tenant retention in the quarter down to 75%-76%?
Yeah. You know, it bounces around from quarter to quarter. If you look at the annual, we're just kind of just under 80%. There is a difference that we are seeing between the, you know, the legacy HR, the legacy HTA portfolio. We did see as a result of, I think, some of the distraction that the HTA team was going through over the last few years with their sale and things that frankly, you know, we saw some kind of lower customer service scores that was playing through. I think that that's impacting, you know, some of that lower retention.
That's also an opportunity that our team sees and that they're very excited about of kind of going in and showing the, you know, positive customer service experience that we're used to providing. You know, as we, as we look forward, I would say, you know, we see that improving from that, you know, the low end of that 75%-90%, you know, closer up to, you know, 80% or 80%+, in terms of that retention ratio.
Okay. Thank you.
Thank you. You have no further questions on the line. I'd like to hand it back to Todd Meredith, the CEO, for any final remarks.
Thank you. Thanks everybody for joining us today. We'll see some of you at some conferences next week. Everybody have a great day. Thank you.
Thank you. This does conclude today's call. You may now disconnect your line and have a lovely day.