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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Thank you 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. [Operator Instructions]
Thank you. I would now like to hand the call over to our host, Ron Hubbard of Investor Relations. Sir, you may begin your conference call.
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 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; 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. And thank you, everyone, for joining us for our fourth quarter 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 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 the acquisitions to be modest on these selected properties to 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 5s. This improved financing has pulled MOB cap rates a bit lower since November towards 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 and 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 square feet of signed leases yet to take occupancy. This equates to roughly 150 basis points of gross absorption. We aim to capture most of this in the first half of '23, 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. And 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. And as inflation moderates and interest rates stabilize, we'll add accretive acquisitions to bolster our growth profile.
Now 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, and 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 noncash 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 premerger combined G&A. There are still some marginal synergies yet to be realized over the next two quarters, but 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 5 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 square feet 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, but inflationary 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 5 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 '23 giving 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 6.4x. Target leverage continues to be in the low to mid-6s. 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 to $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 basis points to 200 basis points above stabilized acquisition cap rates. Redevelopment is expected to produce richer returns in the 8% to 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 2-phase MOB development in Orlando. This year, across our $235 million active pipeline, we expect to fund approximately $25 million to $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 filling 1.5 million square feet. 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 square foot 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 agree 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. And in a local example, our brokerage team in Phoenix recently used seven of their brokers to conduct 11 tours in one day. Such a 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 and 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 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.
[Operator Instructions] The first question we have comes from Austin Wurschmidt of KeyBanc.
Just first question, kind of hitting a little bit on some of the strategic objectives looking forward. I mean 2023 same-store NOI growth guidance of 3% to 4% has some implied acceleration from the fourth quarter, and it's kind of consistent with what you've talked about. But I'm curious what your latest thoughts are on the time line of getting you into that high end of that 3% to 5% same-store NOI growth opportunity that you guys have talked about following the merger. Is 2024 a reasonable timeframe to think that you could see that continue to accelerate?
Thanks, Austin. And Brika, if you don't mind, we're having a little bit of a quiet volume. So if you can add some volume for audience? That would be great. But Austin, for your question, I think just to clarify, our guidance for '23 on same-store NOI growth is 2.5% to 3.5%. But 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. And so we see that translating in '23 kind of throughout the year from the lower end of that range where we finished '22 to sort of the higher end of the range through the balance of '23. So 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 '24, building off that momentum. So I think, again, 2.5% to 3.5% for the year, but sort of a build in that range throughout the year.
Sorry about that. I was looking at the cash leasing spreads.
Yes, that's certainly an important driver rather a big contributor.
And along similar lines, you've talked about the upside from driving occupancy. You noted some of the [SNO] pipeline that you've got today with a significant portion of that opportunity across HTA. So how did you embed some of that -- 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 -- that we should think about? Any near-term headwinds that are offsetting some of these benefits today as that starts to build over time?
Yes. No, I think you can kind of see what we're trying to get through with the different components of the same store. We are expecting to get some absorption as well as some improvement and our cash leasing spreads versus what we saw in 2022 as we bring the combination of the two companies together.
One piece that is it's a bit of a headwind compared to historical experience, but an improving picture from where we've been in 2022, our operating expenses. As I talked about, operating expenses are now for us running around 6%. That's still elevated from our typical norm of 2% to 2.5%. But we are seeing some signs that, that could start moving in the right direction, but we don't anticipate that we'll get all the way back to that 2% to 2.5% in 2023. But we think it 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.
Your next question comes from Nick Yulico of Scotiabank.
Great. First question is just in terms of interest expense, I know you didn't give guidance on it specifically, but I wanted to just see if you -- if there's any way we can get a feel roughly for how, I guess, cash interest expense without the mark-to-market on the debt could look like this year.
Yes. 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 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 to overall growth on a per share amount for the year. So that gives you a little bit of the magnitude of the impact, but we'll have to kind of continue to watch that through the balance of '23.
Okay. That's helpful. And I guess just my follow-up question was on interest expense. I mean, I know you guys are excluding that merger fair value adjustment because it's noncash from your normalized FFO, and I know you were considering doing that because it's a large impact that you're having. But at the same time, other REITs aren't doing that, granted other REITs don't have as big of an issue that you're facing. But I just want to hear a little bit more about the decision to remove that from your -- the rationale to remove that from your normalized FFO calculation.
Kris?
Yes. We did consider that and look at that. And I think you're right. When you look at the impact that it has on us compared to peers and what's going on right now, the rapid change in interest rates, it is different. So we ended up with almost half of our balance sheet being mark-to-market, which resulted in over 20% of our income statement interest expense being noncash related to this fair value adjustment.
So we had some of our analysts really, we spoke to all of our analysts on this as well as a lot of our investors. And the consensus was that given the size and the unusual nature of that, it was going to create a lot of comparability issues. And so the recommendation is that we make this normalizing adjustment that we pointed out. And I will remind you, being noncash, this is an FFO item. It's not a FAD item. So that was the thought process that went into that decision.
And I would just add that -- yes, clearly, it was more material because of the merger and just the fact that we were buying HTA and, therefore, 60% larger balance sheet or a portion of the combined balance sheet. That's a huge, huge amount, as Kris said. And so we don't have any real maturity, significant maturities, until '25. So there's -- like everyone, as we refinance in the future, we'll deal with the cash change like everyone in real time, but we're in a really good position on that. So feel very good about the balance sheet, and it helps comparability, as Kris said.
We now have Rich Anderson with SMBC.
So on the dividend, you said high 90s type of FAD payout. Hear me okay?
Yes.
Okay. Sorry about that. I had some feedback. And then Kris, you mentioned the sensitivity to higher interest rates and what that does to the bottom line. Let's say it's not high 90s, but it's 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 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 is going. But like everyone, we're using heuristics and just trying to manage appropriately. But I think the short answer is we are confident that the operational improvements we're seeing that will read through are very strong in near term. And we think those can go a great deal to offset what might be, hopefully, short-term rising interest rates. And then like everybody looking at forward curves, seeing not if, but when the rates start to come down.
So we feel very good about that momentum. And even if, as you just said, we found ourselves right at triple digits. I think we're very comfortable that the operational improvements are real in near term in '23, but also in '24. So we feel very comfortable that, that should drive down fairly quickly just through operational improvement. So we do not, at this point, anticipate any notion of any cut. Obviously, we're all watching the markets and looking at the extent of this. So that's something we re-evaluate as a Board and as a management team every quarter, every year. But for now, that's our outlook is that we feel very comfortable with where it's at.
One thing I would add to that, Rich, is that 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. So that's a good problem to have. And we look at that as growth capital that will enhance long-term cash flow and value. But that's something that if you're dealing with that in the short term, that doesn't point to a long-term dividend issue.
Okay. And maybe -- I don't know if it's an obvious question, but if you're -- that was 80% of payout would you have bothered doing the swaps at this point? Or was that -- was the tail wagging the dog there in terms of $600 million in swaps recently at this level in today's market?
Yes. 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%. And 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. So we're still trying to take a balanced view on where rates are right now.
Okay. And then I just had kind of weird question. I live dangerously what is 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 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 weren't available. What's the reason for that?
That's a fair point. 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. And that was kind of just the plan that said, hey, let's give ourselves really the maximum amount of time given the lift post-merger in the 10-K and audit, first full audit post-merger. So 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. And I think you'll see us kind of return to a more normal schedule throughout the year. So I wouldn't expect that this trend continues.
We now have Michael Griffin of Citi.
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 burn-offs from January? And I know you talked about the interest rate sensitivity scenario. But what impact potentially the shares could see of that swap burning off from an interest expense perspective?
Yes. No, it doesn't because that was a 12/31 run rate number where that swap expiration occurred in late January. So 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.
Got you. That's a helpful clarification. And then just on the targeted dispositions and guidance. 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 buyer pool or pricing expectations? And I did want to clarify, are any of these related to that $500 million of incremental dispositions you had initially targeted with the merger? Or are they legacy assets? Is there -- maybe they're lower performing assets, tougher to lease, but any clarity around that would be helpful?
Yes. I think if you look at -- we finished the merger-related dispositions, and we now are looking ahead. And I think the way we think about the $200 million to $300 million is continued and 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 the time or the expectations for growth are lower than what we're looking for. So 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 want to be in the long term.
As far as pricing, I mean, I think right now, we've seen some swings in interest rates over the past couple of quarters. I think we've seen the debt market is really driving pricing on MOBs. And if you go back to the fall, debt costs were kind of gone up to the mid to high 6s probably, and we've seen about a 100 basis point swing back down; and then now probably from there, about another 50 basis points up. So we think that that's driving the cap rates. And right now, we're sort of looking at cap rates that are moving towards around 6%. So 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 could be above that gave you below that. It just depends on what the asset is and the appetite out there.
We now have Steven of Barclays.
It's Steve Valiquette from Barclays. All the questions, I think, around both the market for acquisitions and divestitures were kind of covered at this point. So 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 better ability to control costs, et cetera? I just want to hear more about kind of the trends there, would be helpful.
Yes, 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, and a good portion of that related to some successful property tax appeals. Excluding those property tax appeals, where we see our operating expenses right at around 6%, which is 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 '23, we could see some continued improvement. A lot of that comes from the utility side. That's one of our largest expenses.
Kind of over 20% of our operating expenses are related to utilities. And those were -- utility expenses just on the rate side, we're up double digit in '22 over '21. As you look at the forecast moving into '23, you see that moderating. We've even seen some forecasts that show it declining. I'm not ready to latch onto that, but if you can just start to see that come down a bit from what we saw in '22, that gives a lot of line of sight to feel much better about where overall operating expenses to trend throughout '23.
We now have Jonathan Hughes of Raymond James.
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 $1.45 this year and the $1.24 annualized 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 the operational upside that was embedded in those projections has gone and maybe it's just simply delayed rather than no longer achievable?
Jonathan, I think, number one, the projections you're referring to, clearly, were in a very different environment. I think everybody is dealing with the interest rates and to different degrees. I don't think there's any change in the operational picture whatsoever. There's been no material delay or decline in the opportunity. In fact, I think we're seeing very strong signs, as Rob walked through some specific examples. I talked about what we're seeing come through on same store.
So we're really not seeing anything that is operationally negative. I think this environment for a lot of folks has two big impacts. You've got your operating fundamental business. How is it doing? How is demand? What are the trends? And then what everybody is dealing with is a dramatic C-level change in interest rates. Unless you just were prescient, perfectly prescient, maybe lucky, 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, but certainly see a large impact but see a rebound as things moderate coming from that side as well. So again, that's kind of what informs our swap position fixing those rates. So I think operationally, we're very optimistic and bullish about where we're headed. So I think, Kris, unless you have something to add, I think the majority of that would be the interest rate environment is the impact there.
Yes. And we do still enter the space set to be able to achieve on the operational upside. And we're -- that's kind of what we're pointing to now, is being able to have achieved the funding of the dividend, 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 need to execute on, third main kind of operational upside. And that's what Rob was hitting on that we're -- we've kind of set that foundation, and we're seeing good indications to be able to start achieving that as we move through '23 and into '24.
Okay. That's helpful. I guess maybe on the operational side then. Is there some expected vacancy in the portfolio that's maybe preventing absorption from running a little higher? I think the midpoint is what, 60 bps. I think it was 50 bps of absorption last year. So I'm just trying to -- it is improving. I'm just trying to square some of the bullish comments for the strength of the outpatient business that you mentioned earlier with just that what I would have thought maybe was more absorption upside.
Yes. One comment there on the guidance is that, that is overall same-store. So that's multi-tenant and single tenant. We are -- you're somewhat diluted by the fact that your single tenant tends to run closer to 100% occupancy, and you don't expect a lot of changes. So it gets a little diluted by that if you look at the ratio, so it's really a more bullish sentiment on just multi-tenant, which is where the opportunity lies. So I think to your point, there's a little more than what I would call 40 to 80 as our guide is for the total behind the multi-tenant, more 50 to 100-plus basis points.
The only other comment, though, that I would add is that we're very bullish. We see a lot of early signs. We're getting the leasing momentum underway. But it takes -- there's a process for build-out. We've got this pent-up square feet, plus of occupied but not yet -- or excuse me, leased but not yet occupied. And building that up over time -- it takes a little time, and then it might take six months plus build off the space, convert it to occupancy. So 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 '24.
All right. And then just one more for me. Just back on the kind of run rate FAD and dividend coverage, and you answered most of it with the prior questions. But can -- I don't think -- can you just remind us of what's the target payout ratio? Kris, then you said it hit kind of high 90s this year, but where can we expect that over the longer term?
Yes. I would say we will continue to drive that lower. And you actually have seen that in our history. We were at a point in time going back eight, 10 years ago, we were over 100%. And through the improvement in the portfolio and growth, we were able to drive that down into the mid- to high 80s. And -- but our expectation from there was to continue to drive it lower. That was before some of these interest expense pressures and things that we've talked about. So long term, our goal is to continue to drive that lower with -- at the same time, being able to provide some growth in the underlying dividend.
Yes. I think in simple terms, below 90 is certainly directionally where we want to get back to. But we're obviously navigating the current environment and certainly want to see it go into the 80s in the not-too-distant future.
We now have Mike Mueller of JPM.
Kris, I think you talked about some of the swaps not being in the $0.41 run rate. So when you layer everything into it, the full impact of swaps and then 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?
Yes. As we start looking at the end of '23, it does come a bit once again back to interest rates. But we -- as I mentioned, 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. So our expectation is we get to the end of the year that we should be able to outpace the pressures on interest rates that would have us ending '23 and 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 some marginal acquisitions as well as our development.
Got it. And then 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 '24 and '25 in terms of starts -- annual starts?
Yes. I think if you look at our prospective pipeline, you're right, it's about $350 million. There's about $200 million of that, that we've slated to -- expect to start second half of this year. So if you combine that with the existing pipeline of $235 million, there will be some of those that are rolling off, but we think that going into 2024, we could have six new starts towards the end of this year. First of next year, roughly $200 million. And that would equate to a funding run rate of moving from $25 million to $30 million per quarter this year, up to about $50 million per quarter next year. So we're optimistic on those projects and pushing them forward and having a great dialogue with all of the prospective tenants and health system partners.
We now have Tayo Okusanya from Credit Suisse.
Yes. Kris, you just -- your response to Michael was helpful to kind of talk through how the FFO run rate will build up in '23. But when I apply that same logic to kind of how FAD should build up in '23, I mean does it not imply that at some point you do end up meaningfully at kind of a dividend coverage above 100%, especially kind of given you were at 100% in 4Q? There's a dilutive 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, TI leasing commissions as you kind of lease up the portfolio. So I'm just trying to think through that as well in the context of Richard's earlier question about dividend policy.
Yes. As we're looking at it, I think the same fundamentals that we're talking about being able to drive improvement and overall growth of the operations that we're seeing, that will flow through to FAD as well. As I've said in my prepared remarks, is the expectation for the year, we'll probably be in the in that high 90s on the payout ratio. And as Rich said, does that in any particular quarter because the CapEx spend is not as smooth as earnings are. And so you are going to have some variation in any quarter. Could you be over 100% for some period of time? Yes, that's possible. But 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. And so plus or minus any one quarter depending on how you're running your models, that would not be surprising, but we still feel like long term directionally with what we're seeing in terms of internal growth, that we'll be able to balance out this year as well as drive that payout ratio lower in the future.
And that high 90s number just for clarification, is that an average for '23 or that's the 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. And so clearly, we see a pattern year-to-year that fourth quarter is always high. So then you -- if you look at the 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 premerger, and we expect it to be true post-merger. And so you really have to look at the balance of the year, and so 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.
Got you. And then one more if you would indulge me. You're starting to get a lot more information from health care systems right now. Again, their bottom line is also under pressure. We are hearing about them, again, starting to consolidate MOBs, consolidate their regular admin space as they kind of try to improve the bottom line. Could, you just kind of talk a little 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. Yes. I think '22 is a pretty challenging year for everybody saw the interest rate side of the world changed dramatically. But I think in health care, it was particularly challenging on the labor front, as we all know but I think if you look month over -- monthly trends throughout '22, there's a dramatic difference in the first half to the second half. And by the end of the year, that was starting to be much improved, and I think that's obviously a bright spot going into '23 and 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 the interest expense side of the world. So we're seeing some easing there, just like we talked about earlier on inflation, which is really encouraging.
But I think the real takeaway is that there's always rationalization going on by health systems of their space usage. But 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. And I would say everything that we're seeing on the leasing side, everything on the development side underscores that, 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. So I think really outpatient continues to be part of the solution. It doesn't mean they're not going to always be trying to rationalize where they put their care and get it optimized. But I think we're really poised to capture a lot of that incremental demand.
We now have John Pawlowski of Green Street.
I have a follow-up question on the occupancy upside and the multi-tenant square footage you guys outlined on Page 16. Could you just give us a sense when do you think you'll be able to get 90%?
The 90%, so we -- this is something we've certainly talked about through the merger, through investor presentation. We've outlined some upside in NOI dollars and getting to 90% for -- just for context. I think for us, it's early stages. And as Jonathan Hughes just asked, sort of what does '23 look like? Where is that occupancy upside? And we talked about -- I talked about 150 basis points of gross absorption that we're really optimistic about in the early part of '23. On a net basis, 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.
So it's -- 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%. Does that mean it's 10 years were -- and the short answer is no. We don't think it's that long. We think it's the early stages of building that momentum. So it's a multiyear process. We can't say exactly what it is, but we'll keep building that execution year-to-year. But I think it's -- we sort of think of it as a 3-, 4-year time frame, but we've obviously got to sort of put some successes here under our belt to really point to a more specific time frame.
Okay. Understood. And then, Kris, the $10.8 million in merger-related costs in the quarter, what additional costs are left to incur? And are there any other just integration risks that are still looming your minds?
To your second question, no, no big integration risk that we see. We do still have some work to be done. We're still working through combining our -- some of our systems, our accounting system. Fortunately, we were on the same system but on different versions. So we're bringing those together. We do have some consultants that are helping us through that process. So that's one of the merger-related costs that you will still see in the first quarter, and probably there will still be some moving into the second quarter. But 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 '23?
I don't have it right at my fingertips, but it will certainly be coming down from $10 million, I think, in the quarter. So it's going to be less than $20 million.
Okay. Last question for me. Can you just give some context on what drove the decline in the tenant retention in the quarter down to the 75%, 76%?
Yes. 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 legacy HR, 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, we saw some kind of lower customer service scores that was playing through. So I think that that's impacting some of that lower retention. But that's also an opportunity that our team sees and that they're very excited about of kind of going in and showing the positive customer service experience that we're used to providing. So as we look forward, I would say we see that improving from that -- the low end of that 75% to 90%, closer up to 80% or 80%-plus in terms of that retention ratio.
Thank you. We have no further questions on the line. So 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. And everybody, have a great day. Thank you.
Thank you. This does conclude today's call. You may now disconnect your lines, and have a lovely day.