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Healthcare Realty Trust Inc
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Hello, everyone, and welcome to the Healthcare Realty Trust Third Quarter Financial Results. My name is Drew, and I'll be coordinating your call today. [Operator Instructions]
I'd now like to turn the conference over to Ron Hubbard, Vice President of Investor Relations. Please go ahead.
Thank you for joining us today for Healthcare Realty's Third 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, 2021, and Form 10-Qs 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 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 September 30, 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 third quarter earnings call. First, I'd like to say how delighted we are to welcome Ron to Healthcare Realty. Many of you know Ron from Duke. He joined us just three weeks ago, and we look forward to a long and successful partnership. Ron will be with us at NAREIT next week.
Turning to the third quarter. We're pleased to report Healthcare Realty's first results on a post-merger basis. I'd like to thank my colleagues for producing solid operating results, while balancing the extra work related to integration. We're really just getting started. But what's encouraging to me are some early successes.
G&A synergies are well ahead of schedule. Occupancy is improving steadily, and the development pipeline is really strong. These trends are especially helpful in a challenging capital markets environment. Debt costs have risen sharply, both underlying rates and credit spreads. This is true for unsecured debt for public issuers as well as secured financing for private borrowers. On top of this, most banks have pulled back on their funding.
The combination of higher rates and less availability of debt financing has put everyone in price discovery mode. Right now, debt costs are serving as a floor on cap rates to avoid negative leverage.
For MOB transactions, we see debt costs running in the high 5s to the mid-6s. At the moment, MOB cap rates are running about the same level. In the last three months, we've made tremendous progress on our top priority of asset sales. We're pleased to report dispositions approaching $1 billion so far with a clear path to reach $1.1 billion at an overall cap rate of 4.8% by year-end. I'd like to commend my colleagues who worked tirelessly to accomplish this remarkable outcome in the current market environment.
Moving forward, we can afford to be more patient. We currently have a lot of lines in the water. You'll see us sell assets selectively where it makes sense strategically and financially. Any proceeds we generate can be accretively reinvested in the development projects, selective acquisitions or opportunistic stock repurchases.
Another top priority has been integration and organizational realignment. We've realized nearly 50% of expected G&A savings moving into the fourth quarter. We're ahead of schedule and on our way to realizing full annual G&A synergies of $33 million to $36 million.
Operationally, we have the opportunity to boost NOI by even more than G&A savings. To capture this upside, our initial focus has been to realign our leasing and operations team.
Our property management and maintenance teams are staffed much more efficiently to deliver excellent service. And our dedicated project management team is focused on accelerating build-out times, increasing the speed between lease execution and rent commencement.
Our leasing platform is also fully realigned. We're leveraging the brokerage model that has worked so well for Healthcare Realty and applying it to the legacy HCA properties. We're poised to capture leasing momentum as the largest owner and operator of medical office properties.
Healthcare Realty's top 15 markets comprised 60% of total NOI. In these markets, we are on an average of 31 properties, totaling about 1 million square feet or more. With unmatched market scale, our leasing directors and brokerage partners have the relationships and deep market knowledge to capture demand, accelerating Healthcare Realty's occupancy and rent growth.
Our solid third quarter operating results largely reflect a mash-up of legacy results without any operational benefits. We already see encouraging trends. Same-store NOI growth is accelerating, led by 50 basis points of year-over-year occupancy gains.
We also see a meaningful increase in our development and redevelopment pipeline with the potential for much more value creation. Chris and Rob will touch on several areas where we have the opportunity to leverage our cluster model and enhance operational scale to accelerate growth and create value in the coming quarters.
As I reflect where we are post merger, I'm pleased to say we're ahead of our own internal expectations. And looking ahead, we're truly energized by the opportunities in front of us. Healthcare Realty expects to generate the fastest growth in the medical office sector through occupancy gains, rent growth and a growing development pipeline.
I'd also like to point out Healthcare Realty's recent ESG efforts. We recently released our fourth annual corporate responsibility report. And we're also pleased to report our GRESB scored 80 points, a notable improvement over last year and among the top in our peer group.
Looking ahead, we have a meaningful opportunity to apply our successful ESG practices across a much larger portfolio. I'd like to thank my colleagues for making this a priority during a very busy time for Healthcare Realty.
Now I'll turn it over to Kris, for a review of financial results. Kris?
Thanks, Todd. This quarter was marked by great progress on the integration, especially, G&A where we saw early success. On an annualized basis, we realized $16.4 million of synergies, which is effectively 50% of our projected $33 million to $36 million of G&A synergies. This is double the savings we originally projected to generate in the quarter. We expect to revise the remaining 50% of G&A synergies evenly over the next three quarters.
Now before getting into specifics on earnings, I would like to point out that with the merger closing on July 20, third quarter financials represent only a partial period contribution from HTA.
In the supplemental report posted this morning, we also provided pro forma financials to show the full quarter impact of the merger. In addition, to help people better understand results, we provided run rate data, showing the impact of the ongoing asset sales, seasonal utilities and remaining G&A synergies. The pro forma FFO per share for the third quarter was $0.39 and run rate FFO per share is $0.40. These results include almost $12 million or over $0.03 per share of noncash merger-related mark-to-market interest expense.
We also experienced approximately $0.01 of increased cash interest expense due to rising interest rates in the quarter. We provided a table on page five of the supplemental, detailing the adjustments for run rate, FFO, FAD and EBITDA. Please note, the run rate numbers do not include any future growth assumptions.
Looking at the balance sheet, run rate pro forma debt-to-EBITDA is 6.3 times. This assumes the full repayment of the asset sale term loan, which had $423 million outstanding at September 30. Subsequent to quarter end, an additional $136 million of asset sales have closed, we expect the remaining asset sales to repay the term loan to be closed before year-end.
At the end of September, we had fixed interest rates on 81% of outstanding debt. This excludes the soon to be repaid asset sale term loan. Subsequent to the end of the quarter, we completed $250 million of additional interest rate swaps, bringing our current fixed debt ratio to over 85%. We expect to keep our fixed to floating ratio in this range.
Turning to same-store performance. We've seen accelerating growth. I want to point out that the same-store results include the combined legacy HR and HTA portfolios for all eight quarters shown. The same-store properties represent 83% of total portfolio cash NOI. Notably, the combined portfolio has generated sequential improvement in same-store NOI for each of the last four quarters. Same-store NOI growth of 2.8% in the third quarter is up from 2% a year ago.
We expect to build on this momentum moving forward. Strong revenue drivers, helped offset a 9% increase in operating expenses in the third quarter. The expense growth was driven primarily by utilities, which increased 16%. We are generally insulated from the higher than historical operating expenses with 92% of leases having expense pass-throughs. This drove an 11% increase in operating expense recoveries year-over-year.
Looking ahead, the merger provides opportunities to improve overall utility expenses. For example, we've installed real-time electricity monitoring and about half of the legacy HR properties. As indicated in our recently filed corporate responsibility report, we've seen an average 8% reduction in energy consumption after installing these systems. Comparably, none of the HCA properties have real-time electricity monitoring. We currently have over $10 million in sustainability capital projects underway. These projects will help reduce overall energy usage and cost.
Shifting back to rental income. Same-store third quarter revenue per occupied square foot increased 4.4%. This growth was driven by 50 basis points of year-over-year occupancy absorption and cash leasing spreads of 2.9%.
Looking ahead, same-store revenue is poised for accelerating future growth with escalators for leases executed in the quarter being 16 basis points higher than the portfolio average escalators of 2.64%. In particular, we have an opportunity in the legacy HTA assets where escalators are running more than 50 basis points below legacy HR, and cash leasing spreads are about half of the HR assets. We expect to accelerate the growth in the escalators and cash leasing spreads in the legacy HTA assets. This will drive compounding NOI growth.
Now, I'll turn the call over to Rob for further updates on leasing and investment activities.
Thank you, Kris. Since closing the merger with HTA, Healthcare Realty has sold 29 properties for a total of $922 million at a 4.6% cap rate. This includes $489 million closed since we last reported. We expect to close the balance of the transactions related to the special dividend by year-end, bringing the total to over $1.1 billion at a cap rate of approximately 4.8%.
As Todd alluded to, the market for medical office buildings remains in a period of price discovery, likely for the remainder of this year and into next. This has largely been caused by a significant increase in the cost of debt. This increase seems to have created a flow-on cap rates around the 6% level. It's also become more difficult to secure financing, especially for larger portfolios. Transactions greater than about $100 million often need to be syndicated with multiple lenders, increasing the complexity and cost of the financing.
As we move into our next phase of asset sales, we remain active but measured as we navigate this period of price discovery. We are testing the market with multiple smaller offerings, having a wide variety of characteristics to gauge where relative pricing is strongest. We will consider opportunistic sales when it aligns with our long-term portfolio strategy. Any proceeds can be redeployed accretively into our development pipeline or select acquisitions.
Development remains an area where we see the prospect for meaningful investment with higher-yielding risk adjusted returns. Through the merger with HTA, we picked up two active developments in Orlando and Raleigh with a combined budget of $114 million. Together with legacy HR projects, we now have $209 million of active development and redevelopment underway. We expect to fund approximately $20 million to $25 million per quarter for these projects during 2023.
Our long-term embedded development pipeline has also increased through the merger to approximately $2 billion. From this embedded pipeline, we have identified over $300 million of near-term prospective projects. These are made up of opportunities where we have a high degree of control of both timing and project economics. As an example, we inherited a land parcel from HTA adjacent to a hospital in Houston. We are engaged in discussions with the hospital and physicians to lease space in a new 112,000 square foot MOB.
Another example from the legacy HTA portfolio is a redevelopment. This project includes two 60% occupied MOBs on another hospital campus in Houston. A change in hospital ownership is reinvigorating investment and demand on the campus identifying and executing on redevelopment opportunities like this creates a path to increase occupancy across the legacy HTA portfolio.
On the leasing front, we have made considerable progress transitioning legacy HTA's portfolio to our own proven leasing platform. We reconfigured our regional leasing coverage and each of our directors of leasing now has a more efficient portfolio to manage. We have also transitioned almost 75% of the legacy HTA portfolio to third-party brokers.
A key element of our model includes the use of third-party brokers, providing enhanced deal flow and greater market knowledge to increase portfolio occupancy. The response from our brokers and hospital partners to this transition has been incredibly positive. For example, a health system in Dallas reached out to our local team and expressed the desire for more collaboration around their strategic initiatives since we now own more buildings on their campus.
As we've experienced with other hospital center clusters, having a deep relationship with the hospital will drive demand for our MOBs. And the brokerage community is energized by having more leasing options. We've had several of our brokers in top markets articulate how the increased scale and variety of offerings will help them generate greater leasing velocity and improve our occupancy.
The momentum generated by this transition will serve as a foundation for improving occupancy across the portfolio. Notably, bringing the combined portfolio's current multi-tenant occupancy of 85% to 90% will generate over $57 million of annual NOI. This will take multiple years, but generate significant value. And as Chris mentioned earlier, there's further upside from improving key growth drivers such as cash leasing spreads and annual escalators across the legacy HTA portfolio.
I'll note, we've successfully achieved this time and time again with many of our acquisitions. I am proud of the progress made this past quarter to integrate the two portfolios and our teams. Through this process, we are identifying additional areas for future growth. Executing on these will generate substantial upside for our shareholders.
Drew, we're now to open the line for questions.
Thank you. We will now start today's Q&A session. [Operator Instructions] Our first question today comes from Nick Yulico from DB [ph]. Your line is now open.
It's Nick Yulico with Scotiabank. So I guess just in terms of first, Khris, just from a modeling standpoint, could we get the rate on the new swaps at the 250 million? And also just thoughts on why not do even more swaps to reduce floating rate exposure?
Yes. That 250 million is a little over 4%. I think right at 4.12% is the all-in rate on the swaps with a term between 4.5 and five years. And what that does is it brings us a little over 50% fixed on all of our bank debt. And as we look at it, it's really kind of taking a true hedge position as opposed to saying that we know exactly where interest rates are going to be for the next four years, which is the average remaining term on all of our bank debt.
But certainly, that's something that we'll continue to watch and monitor. If we wanted to, we could tip it up a little bit, but I'm not sure that you want to go to 100% fixed right now and not be able to recognize the back end of that forward curve when hopefully rates will start to moderate.
Okay, great. And second question is just on -- I appreciate all the disclosures you gave on pro forma FFO, FAD. If I look at page five of the sup, where you have that sort of adjusted run rate FAD of around $0.33 in the third quarter. How should we think about that as sort of the building block for next year?
And I guess I realize it was done a while ago, but originally, when you put out some of the accretion numbers on the transaction earlier this year, you talked about $1.48, $1.49. 2023 combined FAD realizing interest rates have gone out of favor for that number right now. But I'm just wondering if there's anything else relative to that initial number you put out earlier this year to think about as we're thinking about next year? Thanks.
Nick, this is Todd. I'll jump in. Maybe Kris can add to it. But clearly, as you just pointed out, the big wild card has been interest rates. And so that's had a pretty big impact on all debt costs, as Kris just talked about, managing sort of the exposure on that is key. And the merger was certainly a benefit gave us a larger balance sheet, frankly, moved us to more fixed than we were independently in Healthcare Realty. So, there was some benefit there.
But that's what's really causing a 2023 outlook to be different than it was three, six months ago with rates changing that quickly. So, what we've tried to do here is just sort of start -- really set the starting blocks for what you said, which is building upon that with the building of growth versus sort of the headwinds we're all looking at with interest rates.
So, I think for us, we view this as interest rates have not only impacted just your absolute cost of debt, but they also ripple through to things like acquisition activity, disposition activity, the types of accretion that you would normally have in this model.
So, I think for us, that's largely a pause beyond the asset sales that we're focused on today. In terms of future acquisition volume, we're not trying to project what that might be at this point. We need things to settle out like everyone.
So, I think our view is really the building -- the key building block is what you heard all of us talking about, which is occupancy upside. Clearly, we have strong fundamental growth drivers that compound rental growth rates, cash leasing spreads, those types of things. But it's really the opportunity Rob articulated to generate significant NOI through occupancy upside.
So, we kind of view that as 3% to 5% growth on fundamental contractual escalations, cash, leasing spreads, plus occupancy. The one headwind in that, that Kris touched on which is also a wildcard is inflation and operating expenses. The good news is we can still have strong same-store performance, but it can soften it if expenses aren't cooling down a little bit. So -- those are the building blocks we think, sort of 3% to 5% operating growth. And then it's really kind of the question of interest rates. What do you look at it with interest rates. And Kris, you might touch on sort of how we think about every percent change in interest rates.
Yeah. So if you look at it right now, about a 1% change in interest expense reduces our overall growth by about 1.5%.
So it's kind of those two building blocks are the main focus right now. Obviously, as the market settles out with price discovery, we can start to look back at things like does it make sense to be selling assets, recycling accretively to acquisitions. At some point, does it make sense that cost of capital makes sense relative to acquisition cap rates, development yields, that kind of thing. So we're kind of putting those pieces in the back burner in the current moment.
All right. Very helpful. Thanks, Todd, Kris.
Our next question comes from Austin Wurschmidt from KeyBanc. Your line is now open.
Hi. Thanks everybody. Todd, you highlighted the realignment of your leasing and operations teams. And I was just wondering if you could give a little bit more detail as to what exactly that means and why maybe they were separated historically as we think about sort of that occupancy opportunity that you've continued to talk about?
Sure. I mean the realignment clearly is taking the two portfolios. That was nearly 70% overlap in markets. So that was obviously a huge opportunity to get more efficient, as Rob said, with our leasing directors and really give them more assets, quality assets in fewer markets so they can focus more on transactions in those markets and be smarter accelerate those relationships with health systems. And then the same thing with brokers. But I think the key difference was if you think about it, we essentially pulled about half -- we're able to kind of sort of what I would say is take the top talent, the high performers of both companies on leasing and where it made sense geographically with their market knowledge, their relationships and reorganize that.
And if you recall, HCA had a very internal internally driven leasing process, not really using brokers to represent the portfolio assets. And so that's a pretty big shift. So going to the Healthcare Realty model of using brokers really getting access to all deal flow, as Rob described. So that's been a real focus of ours is getting the leasing directors, our employees aligned on their portfolios, getting the top talent there. making the most of that more efficiently, but then also getting brokers in place. And really for all these HTA assets that did not have brokers. So it's an organizational process. And I think in three months' time, it's been a really encouraging accomplishment.
And I'm just curious if you can then kind of give us what the leasing pipeline looks like today? What's your thoughts on sort of near-term occupancy gains and sort of the signed but not occupied backlog in the combined portfolio?
Yeah. I think, again, I mentioned that their operating results for the third quarter are just really largely a mashup of the two companies without a lot of this performance enhancement that should come from the combination. But encouragingly, you saw the last two or three quarters, Healthcare Realty's portfolio had been building momentum on occupancy gains. HTAs was lagging a little, but it was sort of pent-up progress and improvement, and we're starting to see that come through here in the third quarter. So that's encouraging. You saw that 50 basis points year-over-year. So I think that's the baseline momentum that we're talking about that we think can continue to carry forward. But it's really sort of what can all the benefits of the merger due to accelerate that. So I think it's thinking how do we move 50 basis points to 75, 100 basis points year-over-year. And that has a material benefit to the rate of growth on same-store and the overall NOI growth, that 3% to 5% level that I was talking about earlier. So that's really what we're seeing. The lease, but unoccupied, Kris, you got that.
Yes. It's just over 500,000 square feet of leases that are in the process of build-out that ends up being about 1.5% of total square feet.
And then sticking kind of operationally last one for me here is, why are leasing spreads so much lower in the HTA portfolio? I think you said they were about half. And how much of that spread do you think you can realistically close versus HR's legacy portfolio? Thanks.
Yes. Yes, I think if you look at -- there were about half, I think if you look at where we've been running -- kind of been running on average of about 3.5%, and I think that's with the realignment that we discussed in terms of more -- giving our leasing team more building, more square footage in the market, deeper relationships and transitioning to that broker model. We think that we can close that gap over time and move that lower cash leasing spread that we're seeing in the HCA portfolio up to something that resembles where we've been operating historically.
And I think a big part of it, Austin, is to just a laser focus on that priority. That's been a huge real boost, I think, to Healthcare Realty for the last seven, eight 8 years is really just being very focused on that. And that's something that I think -- it's not that HTA and other MOB operators don't look at it. But it's just -- we think we have a very well defined focus on that. And I think our team has organized the way Rob described, are able to produce that.
So again, if we're looking at something that's a little less than two versus something that's running three to four. We think we can close that gap and now it's so much overlap in these markets, the same brokers, the same leasing directors internally, we think we can take that focus and really lift that rate across the HTA portfolio.
Thanks, guys.
Thank you.
Our next question today comes from Juan Sanabria from BMO Capital.
Hi. Just hoping to speak a little bit more about the dispositions. I was confused maybe a little bit by some of the numbers, Kris, you threw out there. I mean, it sounds like there's about $100 million left of dispositions, but there's still $400 million-plus left on the term loans. So I just wanted to make sure I understood that correctly.
And then secondly, I mean, what are the realistic prospects for further dispositions, which you had previously highlighted as a potential source to fund the buyback at this point? I mean, what's a good earmark for kind of expectations for 2023, as you sit here today, granted that there's a ton of uncertainty in the markets and where rates are going, but just curious on your thoughts there.
Yes. I can touch on that. So basically, the way to think about it is the $423 million that was outstanding at the end of the third quarter has been paid down, because we did have, after quarter closed, we had an additional $136 million of asset sales that closed in October. We have another $100 million or so that are scheduled to close here in November kind of leaving the balance there to get to the full paydown in December. So that's kind of the progression on asset sales and the pay down of the debt.
And then as you think about dispositions going into your second question on just expectations for 2023, I think that's something I would say, as you pointed out, a little I think it's a little presumptive to know what that would be for 2023, but I understand the modeling question.
Before you will recall, we talked about a Phase 2, $500 million to $1 billion. Certainly, we're not we're not in that realm. I think with what's going on in the market today, Rob describing sort of how we're looking at a lot of different smaller transactions in the market, looking at something that maybe is in the $250 million, $300 million range is probably not an unreasonable, spot to think about for the year. But I think that's going to evolve quarter-by-quarter as price discovery unfolds.
So -- you can even see in some of the assets that Chris just went through in November and December. I mean, those cap rates. I mean, we had the luxury that we had sold the lower cap rate assets sooner, so we were working from a 4.6% and we had a little room to sell at cap rates that are maybe six or so on average here more recently.
And I think that's kind of where your head has to be, if you want to sell assets. And it's almost quality dam. It doesn't matter. You're just not going to find many people willing to pay too much. I mean, maybe a few all-cash buyers will -- or is there something unique about the property is un-stabilized or something that you could get a lower cap rate.
So I think for us, we'll just be measured. I think that's the word patient and measure, these words we're using is just kind of feeling our way through this price discovery. And I think with such a huge portfolio. We've got a lot of opportunity to really discover early where prices are and make the best of that. We think we've got lots of accretive choices to redeploy that capital.
And you flagged $2 billion kind of enhanced or bigger redevelopment, development pipeline that you could maybe do $300 million. So just curious, the timing of that $300 million and the kind of the cadence of capital spend and the funding for that.
And then, kind of as part of that, what yield would you are expecting? And if you could just benchmark that to kind of the 6% you flagged as your cost of debt just to get a sense of how accretive that could potentially be for the company?
Sure. This is Rob. On the -- as I mentioned earlier for 2023, we're looking at about $20 million to $25 million of funding, and that's really related to the current pipeline. As you move to that $300 million prospective pipeline, I'll point out those -- what's really encouraging about those projects is that we control those either through.
We own the land. We have the relationship with the developer, something that really allows us to be measured and to work with the health system and physicians in terms of planning and generating the right economics for us.
And so I think as we think about timing of that, we've play out sort of the first projects would possibly started towards the end of 2023 and then, really move into 2024, before we would have to start funding anything out of those.
Those are our expectations right now. Those projects are still early. We're still in the planning phase. We're having great dialogue with those health systems and those physician groups.
But as you guys know, and as we've communicated before, these types of developments take time, the quality developments take time. And so we think that into 2030 and into 2024 will be where we'll have to start thinking about funding those.
And probably say $20 million to $25 million next year maybe that picks up into that $25 million to $50 million range per quarter for 2024. In terms of yields, yeah, you said -- you mentioned the 6% cap rate that we're seeing right now kind of sort of marking as the cost of -- to sell assets. And we really view that as a proxy for our cost of capital. And so, traditionally, we said about 100 to 200 basis points over our cost of capital is where we want to be on developments. And for that group, that $300 million of developments and redevelopments, that's the range that we're targeting, kind of, that -- right now, that 7% to 8% initial yield, stabilized yield on those deals.
So, certainly, as I mentioned, the control over those projects and the -- we can control the timing and really manage the economics, because we control the projects. And so, as we move forward, if the environment shifts, if costs rise, if capital cost change, then we can certainly be mindful of that and adjust. But that's the range we're looking at right now.
Thank you, guys.
Our next question comes from Michael Griffin from Citi. Please, go ahead.
Thanks. It's Nick Yosuke [ph] with Michael. Maybe just on those asset sales from the quarter at a 4.6% relative to where cap rates are today, is that just a timing mismatch that you guys got the timing right there, or is there anything about those assets either from an occupancy or near-term rent growth opportunity that makes the 4.6% not really a stabilized cap rate?
No. I mean, there's certainly a variety of cap rates within that. I mean, within the 4.6, I would say, there's some things in the -- there are maybe one or two that have a little bit of lower occupancy as you point out.
In fact, a couple of -- or group of assets we sold into the JV with CBRE would fit that description. But again, that's relatively small in the mixture. I think, the overall occupancy is high 80s of everything we sold so far. So it's not a material difference.
But you also have some assets, some deals that are in the 6s, for sure. So it's a range. We had a few people stepping up to some very aggressive cap rates that reflected the environment at that time. So, certainly, nothing material that would say, oh, that 4.6% is materially higher on a stabilized basis.
Certainly, 4.6% is just a pit-stop on the way to 4.8%. It's not as though we think 4.6% is the norm even then. So I think 4.8% is really still where we're focused. I think if you use the run rate table, you can begin to, sort of, see how that's shifting a little higher in some of these later sales, but that was kind of by design, and we're very glad to have some of that lower cap rate dispositions completed behind us.
Thanks. That's helpful. And then, just maybe on the buyer underwriting or how you're even thinking about underwriting from an IRR perspective. Obviously, the cap rates have moved up. Is there anything from a growth perspective that may have changed over the next three to five years, would you think either from a transaction IRR standpoint?
Are you talking about on sales or how we look at IRRs for what we're buying?
How you look at it and how you think a buyer would be, either how you're looking at acquisitions if you're underwriting today or just kind of broadly, how the broader market is underwriting things? Just trying to think about how changes have occurred over last six months, obviously, cap rates are up.
Yes.
Trying to get a sense of where IRRs…
I mean, that's the big one, Nick. I mean, for sure, is the cap rate. And if you think -- the other big moving part would be, yes, the growth profile that you would expect. I think broadly speaking, for the business, I think people are still going to be in the 2 to 3 range when they think about growth.
And then it's going to come down to the specific situation that they -- what are the contractual escalators, what's the occupancy, what's the ability to drive that based on market rents and where you are relative to that. What are -- what's the CapEx side? I mean, that's an important piece as well.
So, I don't think I see anything that's fundamentally shifting the landscape beyond cap rates. I think people are sort of trying to wrap their head around the old bogey of IRR was in the 7% range unlevered, that now 8%, because cap rates have moved 100 basis points.
I mean that's where I think price discovery is focused. And I think maybe the one nuance to us, which you've seen us do for some time is, we do look at the growth rate a little differently because of our cluster model and our market scale. We do think we can go in there and it's kind of all the things we just talked about.
I mean we're looking at that same idea that we can accelerate growth from, what I would call the low end of the 2% to 3% range to the 3% range or better, especially if you add occupancy in the HTA legacy portfolio. And even the HR portfolio being strengthened by enhanced scale. So, I think we do look at it, where there's opportunity to accelerate growth. But I think, broadly speaking, people are still looking at 2% to 3%. And I don't see sort of a systemic challenge to that 2% to 3% concept.
Thanks. Appreciate it.
Sure.
Our next question comes from Rich Anderson from SMBC. Please go ahead.
Thanks. Just a quick clarification first to Kris. You saw -- 1% increase in interest expense creates a 1.5% impact on FFO. Did you mean a 1% increase in interest rates?
Yes. I probably misspoke. And technically, we should be saying one percentage point, 100 basis points, not 1% change. But yes, I think you got the idea.
Yes. Okay. I thought. I just want to make sure I understood that. The side-by-side, I did myself before the call, what you guys look like from a re-leasing an escalator perspective relative to the combined company. You went through that in some detail. So one part that struck me as interesting was, today the combined company, 26% of the portfolio is between 0% and 3% escalators. You guys were exactly 0% in that range as a stand-alone company.
I imagine it's going to take some time to improve upon that statistic, get that 26% up into the upper echelon category. So when you think about the timing of all these escalator improvements to the portfolio, cash releasing spreads and so on. Is that -- it sounds like it's going to be like a three or four year type of kind of situation. Is that fair to say?
I think in terms of -- to your point of being able to capture all of it, yes, it does take multiple years. If you look at our weighted average lease term, that has to flow through. But in any particular quarter, when we laid that out in terms of what the spreads are in each quarter to give a bit more detail and show some that distribution behind the average. But it does move around quarter-to-quarter.
The consistency that you have seen is that FAD part of the distribution is that 3% to 4%. So, that's still there. But as you know, Rich, one of the things that we've talked about is we've had a focus on this for the last seven, eight years, is changing that distribution, reducing the amount that are negative or that zero to 3%, so that you can latch the fat end of the tail, the strong end at the over 4%, which some of those are even double-digits, really start to show through in terms of the average.
So, that's -- I think that's what's going to be our focus. And the expectation is that we're able to continue to improve that over time, which – and I think it goes back a bit to what Rob mentioned that, this is something that we've been doing on acquisitions for years. So, what we see in the HTA portfolio is not dissimilar from what we've seen in other properties and other portfolios we've seen historically. So, we're very encouraged, and we think that, there's a lot of value that can be unlocked. But as you said, it's a multiyear process to capture all of it.
Rich, one of the – I think you're right in observing that, that takes a little time. That's getting organized first. But I think the key phrase that our Head of Leasing would use would be deal discipline and just having a rigorous process around that and a laser focus on the objective. And I think that's just something that, as Kris said, has for us has unfolded and been very effective. It's organizational, but it's also leadership, it's deal discipline. And I think that's what we're encouraged by that we see a huge opportunity to bring that to bear on a significant portfolio.
And frankly, some tailwinds that can help us lift that across both portfolios as well. So that's – as we said, the match up this quarter, as you just pointed out, presents some interesting comparisons or contrast to stand alone HR, and that's really where the opportunity lies.
Okay. On the cap rate discussion and the 4.8% average that you're expecting on the $1.1 billion, is there anything definitional about that cap rate and what you're saying from the 6%-ish type range that you're seeing in the market today? I assume the 4.8% is a backward-looking number. Is that correct?
No. It's really – I mean, both are really thinking about that first year with not a lot of lease up in it. We're pretty disciplined about how we think about – when we talk about a cap rate on the acquisition, we talk about the first year NOI starting now. And it's the same thing on the 4.8% that we're talking about. And the only – I mean, you can kind of pick it up in the run rate table in the supplemental, we're talking cash. We're not talking straight-line rent, because that's going to be a wildcard and unknown.
But I would say, on average, our typical difference between the cash cap rates we're talking about and the non-cash with straight-line rent, maybe 20 to 30 basis points. In the run rate table, it's more subtle than that because we sold a number of – quite a few assets early in the quarter, so there wasn't really much, if any, straight-line rent booked. So there's actually a much smaller difference. So I think the 4.8% goes to like a 4.9%, if you kind of look at the run rate table, so it's more subtle than that.
Across all $1.1 billion.
Yeah, across all of it.
Okay. And last for me. The other thing, when I did my side-by-side is you probably provide your components of FFO guidance. You're not doing that now obviously, a lot of movement around. Do you think by this time next quarter, you'll be able to resurrect the components of FFO of the combined company, or is that going to take some time?
I won't say, we're committed to it by next quarter, but I think conceptually, we like it. It helps us have better conversations with you and your peers, investors, the market in general. So I think we – some form of that will come back, whether it's next quarter or the following. But it makes sense coming into the beginning of 2023. We'll just have to look at that. And I think, again, just with where the market is, some of those things are a little tougher.
So, you might see us do a little more operationally focused. The part about predicting exactly how many acquisitions you're going to do in the year and disposition that part maybe that holds for a little longer. So we're…
Yeah. Understood.
Yeah. No – no big promises, but I think directionally, we favor that.
Okay. Sounds good. Thanks, everyone.
Welcome, Ron.
Our next question comes from Steven Valiquette from Barclays. Please go ahead.
Great. Thanks. Good morning, everyone. So there was a lot of discussion back around the time of the merger and the announcement of merger closed around revenue synergy potential from the deal. Just a couple of questions around that. I guess first with the -- that long-term embedded development pipeline of $2 billion that you talked about is there any part of that you could earmark as incremental opportunity, specifically, related to the merger, or would all the incremental still be forthcoming and would be in addition to that $2 billion? That's the first question. Then I've got a couple of follow-ups based on the answer on that.
Yes. This is Rob. I'll hit your first question there. I think that when we did the merger, we looked at the two pipelines and our embedded pipeline was about $1.2 billion, $1.3 billion. And I think there's -- their pipeline at the time where it was about $600 million $700 million. So if you take the $2 billion that's really what we see as, sort of, the mash up of the two pipelines.
We really believe that there's more behind that. We're just getting into kind of understanding finding opportunities within the portfolio for redevelopment. I think, I cited one on my -- in my prepared remarks in Houston two buildings there they're about 60% occupied. We view that as an opportunity to redevelop those properties and drive occupancy given the favorable environment on that campus. And we think there's more -- there's going to be more behind that. And as we get in we will add to that $2 billion and grow that $2 billion. So we're optimistic and excited about the opportunities that we have ahead of us.
Okay. And then for the $300-plus million of near-term opportunities I mean you showed that list on Page 15 in the supplement so makes our lives easier to track off that. I guess the question is since we're not really in the greatest operating environment for health systems as a whole right now is there any chance that $300-plus million could be canceled, or is that all contractually locked in?
And then also notwithstanding the tough operating environment it sounds like you still think that $300-plus million in near-term opportunity could actually grow based on what you see. I just want to confirm those views just in light of the overall operating environment for health systems. Thanks.
Yes. I touched on your first question. I mean what's -- related to the $300 million certainly those are -- we're not locked in in terms of contractually with those systems to do anything. But those -- the majority of those projects are associated with growing health systems that have growth initiatives in front of them. And they're aligned with leading hospitals in markets like Denver where they have a real initiative to grow, and it's part of their ongoing, kind of, market share plan.
And so certainly, some of these could move around. They could be delayed. Certainly, they could be canceled. But right now, we're having deep dialogue with most of those projects on that list. And so we're very encouraged by what we see going forward and have a high degree of confidence in those projects.
Yes. I think, Steve, I might touch on your comment about the health systems and environment. I think you follow this closely, but certainly health systems are dealing with a pretty historic labor cost problem and availability problem. So no doubt. And then also just following some of the public companies that have reported margins are still for the better hospitals and systems.
Margins are still -- they're still strong, but they're being challenged by those labor and cost increases everywhere. So no doubt, but I think the stronger systems have the wherewithal systemic some of that. The plentiful cash on hand that a lot of not-for-profit systems have, the credit ratings they have, but their cost of capital is going up, too. So in many ways, I think what we can look at is the actual day-to-day conversations we're having are very productive. I think it's going to create opportunity that these health systems may need to lean more into folks like ourselves to execute on their strategic initiatives and rely on third-party capital and operators to get things done, because there their old days of super cheap debt, which is their main source of capital just is much more expensive today like everyone.
So I think we see opportunity there, but we're certainly mindful that they have challenges of just putting together those – those operating plans and initiatives for their growth plans because of staffing challenges. So I think it's kind of like the interest rate environment, it's navigating here quarter-by-quarter to see how it goes.
Okay. All right. Appreciate it. Thanks.
Sure
Our next question comes from Daniel Bernstein from Capital One. Your line is now open.
Hi. Thanks for taking the questions here. I have a question here on the CapEx, which seems a little bit elevated in the quarter. Although, I think in your supplemental, you said it would come down to about 60% of NOI, which still seems a little bit higher than what I was modeling and expecting. So just wondering whether you've changed some of your thoughts on the amount on CapEx relative to FED guidance and -- is that -- is there any other changes in there relative to, say, leasing activity or CapEx needs, which in that legacy HTA portfolio? Thanks.
Yes, Dan, as we look at it, CapEx is something that moves around from quarter-to-quarter. And so it's -- when we typically talk about it, we typically look at it on a trailing 12-month basis. But with merger, that's a little bit more complicated. But digging behind it, if you look at it year-to-date between the two companies, we're running just under 16% -- that's the reason we use that number as well as that's what we used inside of our initial underwriting of the merger of what we expected the combined maintenance CapEx to be.
Now that's kind of a long-term trend number. If we are seeing real benefits in terms of absorption on occupancy and we're spending capital there, that's certainly growth capital that's well worth it. But either side of that 16%, and like I said, it's going to move around from quarter-to-quarter. Fourth quarter is typically one of our higher quarters as just things wrap up. So that -- I wouldn't think that, that would be unusual next quarter either.
Okay. Our potential tenants have signed these leases, are they asking for additional TI relative to, I guess, increasing leasing spreads and increasing rents. We've seen that in the life science space a little bit. Just wondering if you're seeing that in the MOB space as well.
Trend-wise, it's not showing up. I mean if you see our stats that we provide in our supplemental, we even combined with HTA this quarter, it really is not ticking up much. I think situations that involve redevelopment like Rob articulated, certainly, that's a little different game. And so you're going to see more significant dollars to reinvigorate some buildings maybe that have been lagging. But just in the normal course, that goes into maintenance CapEx, I would say we're not seeing any particular trends that suggest that we've been through some elevation of that in past years, but don't see that as a new trend that suddenly that's going to be on the rise. But it's case by case with tenants. I think a lot of health systems aren't looking for a lot of capital and relying on us where it's kind of split that way, whereas the physician side might be from time to time a little more elevated. So it kind of balances out. So I wouldn't say that there's a remarkable trend worth pointing out here.
And I will say that our leasing process and the way that we run the analysis on each of our leases is an IRR-based analysis with hurdle rates. And so if you are looking for more TI, we are going to balance that with making sure we're getting the return on it through higher rents.
Of course. One other quick question here. It seems like your development pipeline is fairly robust, but I would think if you're a merchant builder or a regional builder, you're going to have trouble making the math work for development. Are you seeing any delays in development outside of your portfolio just broadly for the MOB space or any maybe transaction -- development deals that somebody else was going to take and develop that maybe have come your way or the hospitals inquired whether you want to take it or not? Just trying to see maybe development in the industry will be a little bit subdued relative to where demographics are?
Yes, Dan, this is Rob. I think that in terms of developments coming our way, I mean, we're certainly out there in the market. We're dialoguing with all of our health system partners. But we have seen some deals that are out there that are probably headed in the direction that you're articulating. And it's somebody cut a deal at a lower yield on cost. And debt markets have shifted and now they're upside down in terms of the negative leverage. And so certainly, going back to the health system and having that conversation is a tough one. And I think that we could see some opportunities there that will come back our way at adjusted yields that better represent today's cost of capital. So certainly, I haven't seen a ton of it yet, but we think that there's going to be some opportunity out there.
Yes, Dan, it's early, but I think you're exactly right. We saw a little bit of that in the prior cycle 12 years ago, and I think you could see it again, because debt costs are such the driver of these third-party private developers, and that's just breaking havoc on their economics and maybe some of the promises they made. So it's early, but I think that is a bright spot for us.
I do think -- just to add to that, I do think that's what's unique about our pipeline is that we control those opportunities. And so if we can we can manage the economics we can kind of work with the systems because we own the land in many cases, adjacent to the hospital. So I think that's a key difference between us and a merchant builder.
That's great color. Actually, if I could add I'm sorry, -- can I ask one more here
Sure. Go ahead.
Sure. How are you thinking about the trade-off between maybe that future yield on development versus buying back your stock here? I mean the implied yield clearly over 7 obviously, the market some kind of pricing discovery, but it seems like your stock is fairly attractive here.
Yes. I think the difference there is time horizon. If we find ourselves with excess proceeds and just making up a number. But let's say we had an extra $100 million of proceeds and Kris is looking at his choices and saying what's the best? In the near-term that might be stock repurchases. As we look further down the line, I think clearly you start looking at things like development because those can as Rob said be at yields that are even higher than that 7%.
But buying back the stock has growth implications in it too. So -- and we like those prospects. So I think we would look at both very carefully. Stock repurchases are more immediate and known, whereas, development is much more of a long-term planning process. So we think of it more as what Rob said, $20 million to $25 million a quarter. And kind of ticking that up as we go into the latter part of 2023 and 2024 assuming the environment is comfortable. So it's really about excess proceeds from dispositions. So we'll see when we get there.
And maybe it depends on that $500 million to $1 billion, whether that materializes or whether it's a smaller number?
Exactly, yeah.
Okay. That’s fair. Thanks. That’s all I have.
Our next question comes from John Pawlowski from Green Street. Please go ahead.
Thanks. Maybe just a follow-up to just your comments right there, Todd. Can you just give us a sense for the debate of $95 million in acquisitions versus buyback? It seemed that you did have some dry powder and you chose acquisitions over share repurchases. So any color on that debate internally would be great to hear?
Yeah. I mean, that's really a rearview mirror issue, and it's not how we think about it going forward. I mean those were things that were committed much earlier, obviously, at cap rates that made more sense at the time relative to the cost of capital. So I think that framework is just completely shifted in recent times. So I think you will see the quarterly pattern be next to nothing. We might buy one small asset or here or there if it fits into a strategy around a hospital, but you're not going to see large acquisition volume in the fourth quarter for sure. So it's a very different conversation today than it was three months ago, four months ago, even two months ago.
But those are all, as we said, really almost defensive moves around clusters that we have and the opportunity we see with health systems that we don't want to lose. But if you look at the detail in the third quarter, pretty small individual deals. I mean, we're certainly not looking to move material amounts of capital. And again, fourth quarter, you won't see anything like that.
Okay. And then how is same-store NOI growth in the legacy HTA portfolio trending versus expectations you had embedded in prior FAD bridges?
Yeah. No, it's following the trajectory of what's going on with leasing across both portfolios, where occupancy is rebounding. They're a little bit, I think as Todd mentioned earlier, a little bit behind us in terms of that rebound. But they were -- they've been -- if you look back over the last year or so, they've been running more like 1%. And that's starting to move up to the 2% plus, and our expectation is we continue to see that improvement in occupancy that's building that you can start to move that into the mid-two's to even towards 3% on their assets, which we think being combined with what's going on in the legacy HR portfolio, can push us above the high two’s where we are now to 3% plus moving forward.
Okay. So it's -- is it in line with expectations or occupancy said was lagging a little bit?
No. I was saying that their occupancy rebound is behind where HR was. But no, in terms of what is actually the performance and what is happening is in line with what we underwrote.
It was always behind and we knew that was an opportunity coming ahead. And so that hasn't changed.
Okay. Understood. Thank you for the time.
Thanks, John.
Our next question is from Tayo Okusanya from Credit Suisse. Your line is now open.
Yes. Good afternoon. Just a quick focus on just kind of dividend policy and dividend outlook for the quarter, if I'm looking at this right, FAD did not cover the dividend? And then even when you kind of pro forma everything out, you're talking about an FAD of $0.33 on a dividend of $0.31, so the coverage is pretty tight. Just again, as you kind of think out over the next 12 months with some of the synergies and some of the other things going on, how should we kind of think about that going forward?
Yes. Tayo, I think the key thing is that run rate that we've provided is really taking the current operational status adjusting for specifics that we know on asset sales, G&A savings, interest rate impacts, obviously, some noncash as well. But on FAD, it's just cash. I think, our view is that, the key area that doesn't reflect any operational improvement or upside that clearly, we will see playing out as we were just discussing in the quarters ahead and especially in '23. So, I think that's the key.
And then obviously, the countervailing force is interest rates, which we talked about. So it's -- I think our objective here is that, we don't see a material change, but that's something we'll evaluate each quarter as we navigate this environment with interest rates and -- growth -- operational growth might take a little longer, but it's recurring and it's powerful. But interest rates have moved swiftly and that impact is pretty quick. So, I think you just have to balance out the two when you think about dividend policy.
I think on CapEx, Kris touched on that. We don't see a material shift there on anything. The only caveat being that we might invest in some growth capital that generates occupancy upside, but that's not a permanent run rate type of conversation. So I think from a dividend policy standpoint, we'll reevaluate that with the Board in the coming quarter and revisit it and see where we are. But we're not -- we're not overly concerned at this point as to where that is. We think we've got a path to improving. So, I would say it's on…
Okay. Then if I may ask a follow-up. You did make some useful comments about the hospital operator landscape and kind of what you're seeing in regards to demand and again, with renewals, you're kind of getting kind of a really good retention rate. But in regards to new leasing, could you just kind of focus in a little bit more on that and just kind of how the hospital operators are kind of thinking, kind of about -- kind of picking up new space. And I just asked that in the context of looking at your leasing velocity this quarter versus kind of like your last two quarters, of the two separate entities, where it seemed like it slowed a little bit in third quarter relative to 1Q or 2Q?
Yes. I mean, I don't think it's a material change in terms of velocity. I think we're seeing; the conversations we're having in the activity level the amount of leased but unoccupied is staying strong. So, I wouldn't say we're seeing a material change. And certainly, we're mindful of the operating environment. But I think the best feedback is those conversations with whether it's physician groups or hospital groups, and that's robust. And it helps to be in really attractive markets where the demographic growth is really pushing the demand.
And there's still a lot of pent-up need coming out of COVID to address what wasn't sort of growing in terms of space need and lease commitments for the better part of two years. So, I think there's some pent-up demand there that we see that we'll keep that accelerating.
So, notwithstanding, there's labor challenges, there's cost pressures. But I think if anything, shifting more to outpatient is often the answer to the challenges that use health system space. So, we don't see any slowdown on that front yet. And certainly, we're mindful that there's challenges in the operating environment for our customer base.
Thank you.
Thanks Tayo.
Our final question today comes from Mike Mueller from JPMorgan. Please go ahead.
Hi. A couple of questions. One, I think you touched on redevelopment before. But for new development, what sort of return hurdles do you need given debt cost today? And the market rents are they generally justifying the development? That's the first one.
And then the second question is, to the extent that you can find acquisition opportunities where the math pencils out, are you seeing any, I guess, differences in terms of the mix of stuff that would fit the JV versus on balance sheet?
Hey Mike, this is Rob. I'll touch on the development. I think in terms of returns on new development that makes sense right now, and so we've indicated earlier that we think cap rates for MOBs right now are around 6% and kind of view that as our cost of capital if we're selling assets to rotate into new developments. And so we still look for that 100 to 200 basis points over and above the cost of capital today. So, I'm kind of thinking 7% right now today, that 7% to 8%.
And I think in terms of rents and can you justify that. Generally, we're working with health systems who have growth initiatives and are eager to expand outpatient services, and they're buying practices and moving them into these new locations. And so oftentimes, they understand that when they have a new building that's going to come sort of with rates that are at the top of the market and oftentimes, you're pushing the market.
So, certainly see that occurring with the development opportunities that we have where we control these opportunities through land that we own next to the hospital, and it's a great expansion plan.
And really, as Todd mentioned, right now, when their cost of capital is rising is really a valuable piece for them to have that they can rely on that third-party capital to yet still execute on their growth plan.
So, we think it makes a lot of sense, and that's why we continue to focus on health system relationships, deepening those relationships. And when we do development, it's in line with their growth initiatives.
Mike, on your second question about acquisitions, penciling, thinking about balance sheet versus JV, I think you have to go back to a little bit what Rob said. I think right now, if you think about the balance sheet, the way we think about cost of capital is really those disposition cap rates. So, maybe that's in the six range.
And certainly, I think as the market settles out, we'll start to find some of those. We certainly see them already. But as I mentioned before, we're not looking to do much in the way of acquisitions for the time being until some of this settles out a little bit, and we have more clear sight on excess disposition proceeds.
I think the default is always the balance sheet, number one. But where we can make sense of JV, acquisitions really in development to some extent, but focusing on acquisitions is really using that to counterbalance sort of that -- sort of down the center of the fairway type of acquisition we put on our balance sheet, but it's a little bit more off-campus, a little bit more value-add where we can create an extra set of returns for some of the risk profile that might come with those.
We like those two. We can do them on balance sheet, but sometimes it can make some sense. There's also sort of some geography that we try to make sense of. Again, we're not really constrained necessarily with our JV partners on geography, but I think to be a good partner, we want to make sure that we're -- everything we're doing in a particular cluster we want to be in alignment with our partner on those. So we tend to try to whatever we're doing in a particular cluster.
If it's in a JV already, we might do the next acquisition, whatever the style is, whether it's value-add, core or off-campus, whatever it might be. If it's related geographically, we'll probably default to that or at least give them an opportunity. So those are kind of the boundaries of how we think about, I think, balance sheet versus JV, acquisitions.
Got it. Okay. Thank you.
Thanks, Mike.
There are no further questions at this time, so I'll hand you back over to CEO, Todd Meredith for closing remarks.
Thank you Drew, and thank you everybody for joining us this morning. We appreciate everybody's time and joining us and we look forward to seeing many of you at NAREIT out in San Francisco next week. Have a great rest of your week.
That concludes today's Healthcare Realty Trust third quarter financial results. You may now disconnect your lines.