Healthcare Realty Trust Inc

NYSE:HR

Earnings Call Transcript 2017-Q4

[Operator]

Good morning, and welcome to the Healthcare Realty Trust Fourth Quarter Analyst Conference Call. [Operator Instructions]. Please note, this event is being recorded.

I would now like to turn the conference over to Mr. Todd Meredith, President and Chief Executive Officer. Please go ahead.

[Todd Meredith, President & CEO]

Thank you, Phil. Joining me on the call today are Kris Douglas, Rob Hull, Bethany Mancini and Carla Baca. After Miss Baca reads the disclaimer, I'll provide some initial comments, followed by a healthcare policy update from Miss Mancini, and then a review of investment activity by Mr. Hull. And finally, Kris Douglas will cover financial and operating results. Carla?

[Carla Baca, Director, Corporate Communications]

Thank you. 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 Form 10-K filed with the SEC for the year ended December 31, 2017, and in subsequently filed Form 10-Q.

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, FFO, normalized FFO, FFO per share, normalized FFO per share, funds available for distribution, FAD, FAD per share, 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 fourth quarter ended December 31, 2017.

The company's earnings press release, supplemental information, Forms 10-Q and 10-K are available on the company's website.

[Todd Meredith, President & CEO]

Thank you, Carla. We are pleased to report steady fourth quarter results and a strong year for the company in 2017. Healthcare Realty's operational performance exemplifies our commitment to the pursuit of lasting value from on-campus medical office properties, finishing the year with same-store NOI growth of 4%, led by the multi-tenant properties at nearly 5%, a level that surpasses what most have come to expect from medical office portfolios.

Robust internal growth, in our experience, is built on solid leasing fundamentals combined with operating leverage from effective expense management. The company's extensive team of Leasing Directors, Property Managers and Engineers plays a critical role, transferring our collective expertise to the bottom line. In contrast, many landlords seek the safety of long-term net leases, not capturing the value of expense controls or the ability to swiftly adjust to changing economic conditions, such as higher inflation.

The company completed the acquisition of the Atlanta MOBs in November and December. The first quarter of 2018 will benefit from a full quarter of owning these and 3 other properties acquired in the fourth quarter. One of the intangibles of buying the Atlanta portfolio was extending our capacity for development with the seller, Meadows & Ohly. Together, we are already collaborating on prospective development.

For the full year, we were pleased that the company met or exceeded its original objectives across multiple disciplines. We surpassed our initial expectations for acquisition levels and met our objectives for dispositions, resulting in favorable net investment activity. Operational results also exceeded targets, led by the same-store -- led by same-store NOI and made possible by our focus on key elements of the business model, such as cash leasing spreads, tenant retention, contractual rent increases, expense controls and maintenance CapEx.

Overall, a solid year. But more than just hitting the numbers, we advanced key qualitative measures in 2017 that, from experience, will enhance the stability and performance of the portfolio. The company's acquisitions during the year were selective and focused on the campuses of leading investment-grade health systems. A and AA rated systems, such as Fairview and St. Paul, Sutter in the Bay Area, Trinity in D.C, WellStar in Atlanta, Ascension in Chicago and UW Medicine in Seattle. Through decades of investing in medical office buildings, we've learned that affiliated health systems and the specific hospital campus determines, in large measure, the profitability and longevity of an investment and the potential for follow-on investment opportunities, including higher returning developments and redevelopments.

Net investment activity in 2017, including acquisition, developments and dispositions, reflect the deliberate intent to lower the risk profile of the company's portfolio and position it for more sustainable growth. At the end of 2017, 94% of total square footage was medical office versus 88% in 2012. 87% of the company's medical office properties were located on or adjacent to hospital campuses compared to 79% 5 years ago.

Multi-tenant properties now generate 81% of same-store NOI versus 70% in 2012. On these measures, we made more progress in 2017 than any other year over the past five years. These purposeful changes better align our portfolio with leading health systems, ensure long-term demand for space through multiple lease cycles, increase the propensity for more robust durable growth and reduce dependency on any individual tenant.

The heightening shift of healthcare delivery toward outpatient settings also points to steady performance and rising demand for Healthcare Realty's medical office properties. In the post-ACA environment, the company intentionally narrowed its focus to avoid softer markets and weaker operators. And instead, aligned with top health systems in sizable markets with high market share and forward-looking strategies for innovative healthcare delivery.

In 2018, the company's outlook remains bright. We view operational performance at the property level as arguably the most controllable and reliable component of total shareholder return, year in and year out. Consequently, we continue to focus on expanding the compounding potential of the company's portfolio. We expect same-store growth to continue at the pace of 3% to 4%, well above most peers, and again, led by our emphasis on multi-tenant properties.

Given the current market environment, our view of external growth remains tempered. Initially for 2018, we are targeting measured acquisition volume, which could easily be expanded with more favorable market conditions. Having the backdrop of an attractive internal growth profile shapes our selective view of external growth, making the company less dependent on the availability of desirable properties at reasonable prices and favorable capital markets.

In 2017, Healthcare Realty also bolstered its already conservative balance sheet with both equity and debt offerings, further reducing leverage, lowering interest expense and extending its maturities. With debt-to-EBITDA below 5x and no near-term maturities, the company can afford to be patient and confidently invest in properties that fit our long-term objectives, while steadily producing superior operational performance. Bethany?

[Bethany Mancini]

For the healthcare industry, 2017 was a year marked by political headlines and debate over the numerous attempts by Congress to repeal the Affordable Care Act, or ACA. And while it ended without a repeal or major healthcare legislation, the Trump administration worked to unwind significant portions of the bill through executive orders and regulatory actions, seeking to lessen the regulation of healthcare providers and improve flexibility in insurance plans for states.

The activity concerning the ACA federal insurance exchanges, although it dominated headlines, did not have a significant impact on healthcare providers in 2017 as it affects only 5% to 6% of the total insured population. In 2018, the Center for Medicare and Medicaid Services continues to pursue the administration's agenda to improve the reimbursement and operating environment for healthcare providers, and to ease the data reporting burden for physicians under current Medicare policies.

Major healthcare legislation is not expected this year as 2018 is a midterm election when politicians tend to avoid the political consequences of pursuing entitlement reforms. Earlier this month, Congress passed a federal budget bill, surprising many with its bipartisan agreement, to increase healthcare spending for a variety of programs and extend certain delays in taxes. A positive for the industry, although some items more political in nature and not concerning the developments arguably more critical to the healthcare industry, such as rising costs and the need to treat an aging population with cost-effective solutions. However, health system remain focused on addressing these issues, which are directing their plans for the near future more than political events.

All signs in the industry are pointing to sustained growth in outpatient services, driven by underlying demographic trends, cost-saving initiatives and the effects of high deductible insurance plans, which have increased providers' deference to consumers in determining how health services are delivered. Concurrently, as technology has advanced, the level of acuity of procedures able to be performed on an outpatient basis has expanded.

The American Hospital Association reported earnings for not-for-profit hospitals in 2016 up 3.8% and profit margins are steadily improving, up 43% since 2011. This growth has been attributed more to price increases than utilization. Inpatient admissions increased slightly in 2016 after a period of decline between 2011 and 2014, before inching up again. Inpatient services will always remain a key part of any healthcare delivery model, especially with the aging of the population. But outpatient visits have been the avenue for growth, even through economic downturns and an increase in out-of-pocket costs for patients.

Health systems are now looking to capitalize more on growth from outpatient services, largely on-campus, with an integrated approach that can utilize their capital-intensive infrastructure. Health systems recognize their need to expand their revenue sources and pursue innovative depth in each local market, enhancing market share through outpatient services and physician partners. These meaningful trends are having an impact on the demand for hospital-centric, on-campus medical office space and should benefit Healthcare Realty in the years to come.

The importance of physicians to the healthcare industry, specifically to the direction of patients, promotion of outpatient service growth and revenue generated for health systems, demonstrates the critical nature of a strong physician presence on hospital campuses. Healthcare Realty's portfolio of medical office buildings and its development of new facilities should position the company seamlessly within deep-rooted healthcare trends as well as current prevailing strategies for growth. Rob?

[Robert Hull, EVP, Investments]

Last year, we saw a number of large richly priced portfolios in the market. Healthcare Realty remains selective, investing $327 million in 16 properties at a blended cap rate of 5.4%. The company funded $33 million towards the completion of two projects and two development starts. The fungibility score for these investments average 7.8 and the properties are located on or adjacent to market-leading hospital campuses. In contrast, we disposed off 10 properties for $123 million at a blended cap rate of 7% and an average fungibility score of 5.5, well below our new investments. Overall, this intentional rotation reflects our commitment to the disciplined curation of an increasingly valuable portfolio.

Fourth quarter acquisitions totaled $247 million, including the purchase of 8 medical office buildings in Atlanta for $194 million at an estimated first year yield of 5.2%. With a healthy proportion of leases expiring in the first 5 years, we see the potential for future accelerated growth. Seven of the Atlanta properties are on 3 different hospital campuses, associated with A rated WellStar, the dominant healthcare provider in the Atlanta MSA with 21% market share.

In Chicago, we purchased a 100,000 square foot MOB for $29 million at an expected first year yield of 6%. The building is attached to the 311-bed St. Alexius Medical Center. This hospital is owned by Ascension and is part of AMITA Health, a joint operating company formed by Ascension and Adventist. Further, with the recently announced acquisition of 12-hospital Presence Health, Ascension is continuing to grow its position in the Chicago MSA.

During the quarter, we also purchased a 32,000 square foot MOB in Seattle. This property sits on 4 acres adjacent to double A+ rated UW Medicine's Valley Medical Center, where we own 2 other properties and have 1 under development. The building is 95% leased and expected to generate a first year yield of 5.6%. In the near term, this building is well positioned to capture excess demand from the space-constrained hospital campus. Longer term, as the hospital grows and additional Class A medical office space is needed, the site can accommodate up to 150,000 square feet, making it a prime redevelopment opportunity.

2017 transaction volume in the MOB market reached a new level, ending with 2 large portfolios selling to private buyers at very different but aggressive cap rates relative to the underlying asset quality. With plenty of capital available to private buyers, low cap rates will likely persist in the near term. Several sizable transactions are expected to come to market with sellers seeking to take advantage of recent pricing levels. Healthcare Realty remains focused on a solid pipeline of 1- and two-building opportunities, having key predictive attributes for growth and competitive strength. For 2018, we are targeting new acquisitions of $175 million to $225 million at cap rates of 5.25% to 6%.

Turning to development. On the same UW Medicine campus previously mentioned, we commenced construction on our 151,000 square foot on-campus MOB, having a budget of $64 million. The building is 60% leased and productive discussions are underway with the hospital and several prospective third-party tenants.

With $76 million in starts this past year, development and redevelopment remains a source of investment for the highest quality properties at better long-term yields relative to stabilized assets. Our pipeline is primarily focused on existing relationships and provider-driven demand, where we are likely to achieve higher risk-adjusted returns in exchange for some measured lease at risk.

Two projects were completed in 2017 that are expected to generate yields of 7% to 8% upon stabilization over the next 12 to 24 months. Estimated development funding of $30 million to $50 million in 2018 is primarily related to 2 projects currently underway. The expected stabilized yield for these developments are in the low-7s, unchanged from our initial underwriting.

Looking forward to 2018, we expect development for redevelopment starts of $50 million to $100 million, with stabilized cap rates of 6.25% to 7.5%. Depending on initial leasing commitments, these yields represent a 100 to 150 basis point spread over acquisition cap rates.

Dispositions will also continue to be an important piece of our investing strategy. Seven assets in Roanoke, Virginia, subject to an exercise purchase option, will be sold in 2018 for $45.5 million. We expect to sell an additional $25 million to $50 million of properties at an average cap rate of 6.5% to 7.5%.

I am pleased with the composition and incremental growth potential of our 2017 investments. With an active pipeline of acquisitions and developments, our outlook for 2018 remains positive. Kris?

[James Douglas, EVP & CFO]

The results for the fourth quarter reflect progress in refining operations, deploying capital raised and positioning the balance sheet for the future. Normalized FFO for the quarter was $46.8 million. Normalizing items included acquisition costs as well as onetime charges related to debt refinancing, specifically, a $45 million loss on a single return of debt and $767,000 of double interest from the refinancing of the 2021 senior notes.

The $1.6 million increase in normalized FFO over the third quarter was primarily a result of a partial quarter contribution of $1.2 million from the fourth quarter property acquisitions and $1.2 million of interest expense savings from refinancing activities, offset by a noncash charge of $800,000 related to two ground leases, which was primarily attributable to an out-of-period straight line expense adjustment. Normalized FFO per share was unchanged at $0.38 due to the full quarter impact of the 8.3 million share equity offering in August.

Looking forward to the first quarter of 2018, we expect the additional NOI contribution from the fourth quarter acquisitions to increase FFO by $2.1 million. For greater detail on the quarterly changes in FFO, I refer you to the quarter-to-quarter Reconciliation Section on Page 6 of the supplemental. In 2017, we made substantial progress rotating out of slower growing, higher-risk, single-tenant properties, many of which that were not MOBs and into faster-growing, lower risk, multi-tenant, on-campus medical office buildings.

In the fourth quarter of 2017, multi-tenant NOI comprised 81.3% of total same-store NOI for the trailing 12 months compared to 74.8% in the year prior. As one would expect, there is a cap rate differential on the reinvestment of disposition proceeds from -- when upgrading from single to multi-tenant, especially on a GAAP basis. Disposition cap rates in 2017 were 160 basis points higher than for acquisitions or 220 basis points on a GAAP basis.

In addition, dispositions were front-loaded and acquisitions were back loaded during the year, causing a temporary timing impact on FFO. Although this rotation pressures earnings in the short term, the NOI growth and stability of multi-tenant MOBs leads to superior long-term value. Our strong multi-tenant NOI growth, which continued to significantly outpace single-tenant throughout 2017, supports this assertion.

Total same-store NOI for the trailing 12 months ending 12/31/17 increased 4.1%, led by 4.9% growth for the 142 multi-tenant properties and 0.7% for the 19 single-tenant net lease properties.

Moving forward, single-tenant NOI growth is expected to accelerate in the first half of 2018 and surpass the long-term average of 2% per year as a result of recent nonannual rent increases for 2 leases, representing nearly 20% of single-tenant net lease square footage. The rent increased 5% for 1 lease and 7.7% for the other. The 4.9% increase in multi-tenant NOI was due to the operating leverage created by 3.8% growth in revenue and a 2.3% increase in operating expenses. The revenue growth was driven by a 3.1% increase in revenue per average occupied square foot and 70 basis points of additional average occupancy.

In order to advance the strong internal growth that distinguishes our portfolio, we continue to focus and improve upon the 2 major drivers of our multi-tenant revenue model; in-place contractual rent increases and cash leasing spreads. In the fourth quarter, in-place contractual rent increases averaged 2.8%, up from 2.78% in the third quarter and 2.69% a year ago.

Cash leasing spreads in the quarter averaged 3.7% for the 367,000 square feet of same-store renewals, 75% of which had cash leasing spreads of 3% or greater across 17 separate markets. Cash leasing spreads exceeding already strong in-place contractual rent increases points to improved overall revenue and NOI growth in the quarters ahead.

The persistent efforts of our leasing team once again proved successful in 2017, with 1.4 million square feet of executed renewals and cash leasing spreads averaging 5.4%. Multi-tenant retention for the year was 83% as year-end occupancy increased 28,000 square feet to 88%. During the fourth quarter, we also made substantial improvements to our debt maturity schedule and effective interest rate. The refinance of our senior notes due 2021 with the issuance of $300 million of senior notes due 2028 helped to lower our weighted average of effective interest rate by nearly 90 basis points to 3.71% at year-end and extend the weighted average maturity of our senior notes from 61 to 92 months.

Separately, in December, we extended the maturity date of our $150 million term loan to December 2022 and reduced the spread over LIBOR by 10 basis points. We subsequently entered into 4 swaps to fix the interest rate for half of the term loan. Relative to 2016, we closed out 2017 with a greatly improved debt schedule and an overall leverage reduction to below 5x through the equity issued in August. As we move into 2018, we will benefit from our strengthened balance sheet and continue our vigilant emphasis on optimizing the performance of our existing portfolio, both of which insulate us from and allow us to better navigate through uncertainty in the capital markets.

[Todd Meredith, President & CEO]

Thank you, Kris. Operator, that concludes our prepared remarks. We're ready to begin the question-and-answer period.

[Operator]

[Operator Instructions]. The first question comes from Jordan Sadler with KeyBanc Capital Markets.

[Jordan Sadler, KeyBanc Capital Markets]

Just wanted to touch on the transaction environment. It sounds like there you're expecting significant sizable transactions to hit the market, I'm curious -- but it sounds like you wouldn't look to participate. I'm curious where you think pricing is headed and how you're adjusting your underwriting, if at all, given sort of the move in the capital markets?

[Todd Meredith, President & CEO]

Sure. As Rob did mention in his remarks, we certainly know of a few portfolios out there, probably not to the scale that some of the blockbuster deals that Rob mentioned last year. And certainly, it's early. It's hard to know exactly where those cap rates will go. I think Rob mentioned that we expect cap rates to continue to stay fairly low. You have a lot of private buyers and a lot of capital. We probably have this window to continue to be aggressive. The public REITs obviously feeling it a little more directly with the stock prices pulling back. So for us, we'll certainly be careful. I think I used words like tempered and measured, and so did Rob. So that's certainly our outlook. I think you see our guidance being more in line with what we said a year ago. Obviously, we exceeded that in '17. And I think at this point in the year, it feels appropriate to be measured and watch how it plays out. But I'd say it's a little early to say where cap rates are going. We see some room for it to continue to stay low until it plays out a little further and to see how permanent sort of this move is with the public buyers. Anything to add, Rob?

[Robert Hull, EVP, Investments]

No. I would just echo that we're focused on our pipeline of opportunities as I mentioned in that 5.25% to 6% range, so...

[Jordan Sadler, KeyBanc Capital Markets]

I guess, Todd, I would just maybe follow-up with a question regarding the cost of capital. I mean, it seems to me, you'll probably agree that you're trading at a discount to NAV at this point. Does that -- when you say tempered and measured, does that change your willingness to invest? I mean, you've got $200 million of acquisitions in the guide again at cap rates that are at levels below which you are trading. How do you think about that from a tactical perspective as opposed to maybe longer term?

[Todd Meredith, President & CEO]

Sure. We're certainly very aware of where we see the implied cap rate. And I think that's, for us, probably the most important thing to look at on the NAV because when you're in this period like this, a change becomes circular. So I think looking at what the market pricing first on implied cap rate, which, by our math and our schedule, would probably be a 5.8% -- maybe a little over 5.8% currently. So you're right. We're certainly aware of that. We're measuring that carefully against each of the acquisitions that we're looking at. Certainly, we balance it with developments and we look at it a little more broadly maybe than others that don't develop as well. But as Rob said, the guidance range is 5.25% to 6. We see a number of opportunities that are attractive that will make sense at that 5.8% level or upper 5%.

So we see a nice ability to continue to do that $175 million to $225 million. Almost 1/2 of that we're talking about funding with disposition levels this year. So that takes certainly some of that question off the table, as you say, with stock price. And obviously, our leverage is extremely low. And not that we want to run it up by any stretch, but we're recently comfortable in a range where we are today at 4.8% up to -- as much as 5.5% and we'll work within that bandwidth. But I think anything beyond something in that mid -- really lower 5s, we will be cautious around the implied cap rate versus the investment returns we're looking at.

[Jordan Sadler, KeyBanc Capital Markets]

Okay. And then, I was just curious if you could speak to the bit of de-sell in the multi-tenant same-store growth going forward. It looks like your re-leasing spreads and your occupancy are pretty consistent with last year's guide. Is it just tougher comps? Or is there anything else driving that?

[James Douglas, EVP & CFO]

You certainly do have some very strong comps that we've come off of for the last several years. A lot of that has to do with some lease up that we've been able to achieve. The way we typically look at it is really based off of our multi-tenant revenue model and our contractual rent increases, as I mentioned, run about 2.8%. We look at our cash leasing spreads. This last year they grew at 5.4%, which is great. But on a long-term basis, we think somewhere in that 3% to 4% range is certainly sustainable. If we can have periods that we can extend beyond that like we did in 2017, we'll certainly look to do so. But when you put all that together, that kind of gets you into, call it, just a 3%, maybe just over on revenue growth, which -- then running operating expenses around 2%, creating some operating leverage to get you up into the 3.5%, maybe a little bit more without any changes in occupancy. And then, we're continuing to focus on trying to continue to drive occupancy, which could add a little bit of a boost to that 3.5% range and push it up to the 4%, 4.5%.

[Operator]

The next question comes from Chad Vanacore with Stifel.

[Chad Vanacore, Stifel, Nicolaus & Company]

So just looking at your CapEx in the fourth quarter, it looks pretty well elevated. And it looks like you expect a material increase to run through 2018. So what investment projects are behind the increase in CapEx expectation? And then, what type of returns are you expecting compared to other uses of cash flow?

[James Douglas, EVP & CFO]

Yes. In terms of the spend for the quarter, that's going to bounce around from quarter-to-quarter, just as invoices show up for individual projects. Our overall spend for the year on the maintenance CapEx was $46 million, equal to what we spent in 2016. And the percentage of NOI on that was actually a little bit less than we had in 2016. And in terms of our midpoint for our 2018 guidance, it is up slightly, moving from about 17.5% that we had as a percentage of NOI in '17 up to, I think, it was [indiscernible] 19%, 19.5% at the midpoint in 2018. That has a lot to do with just the shift in the portfolio that we talked about of shifting to more multi-tenant and less single-tenant. Single-tenant capital ends up being very, very chunky whenever you have a lease roll. But if you don't have any lease roll, you're not really spending it, where multi-tenant is more consistent. And so now being at 80% to 90% multi-tenant, that's really what's driving that increase in '18 over '17, but certainly within ranges that we feel very comfortable with for a multi-tenant portfolio.

We really look at things on -- as opposed to just the spend, we think it more indicative as looking at your commitments, especially on the TI and leasing commissions. And the TI commitments that we disclosed in the supplemental are certainly in line with what we've seen historically and what we have also seen from our public peers, those that reported [indiscernible] time that actually provide that information. But we feel very comfortable with the commitments that we are making the leases that we're executing.

[Chad Vanacore, Stifel, Nicolaus & Company]

All right. Then just 1 other thing I was curious about. Just looking at changing occupancy in your total portfolio versus same-store portfolio, same-store occupancy was down, total portfolio was up. Am I right that you moved about 120,000 square feet of unleased space to the assets held for sale bucket? And that improved the total portfolio occupancy reported? And then if not, then what drove that difference?

[James Douglas, EVP & CFO]

No. We did move our held for sale, which were, I think, about equal to -- maybe a little bit below our average in terms of occupancy. The way to really read that occupancy reconciliation schedule is that we start with kind of portfolio activity, so our acquisitions, dispositions moving -- this is Page 21 of the supplemental. Things that are kind of moving in and out of the portfolio and things that are being reclassified between same-store -- between acquisitions and same-store. So for the year, we started out on our same-store portfolio at 89.3% at 12/31/16. With the ins and outs, that moved our occupancy to 89.1% for the total same-store portfolio. We then -- through our leasing activity, which shows -- we had a net absorption of 28,000 square feet, which moved our same-store total occupancy up 30 basis points to 89.4%. So you kind of have to look at the moves as well as the absorption. We try to segregate that in that schedule.

[Operator]

The next question comes from Vikram Malhotra with Morgan Stanley.

[Vikram Malhotra, Morgan Stanley]

Just wanted to get a sense of incremental dispositions and maybe further repositioning of the portfolio. You mentioned you've been sort of pruning the portfolio a little bit more over the last 2 years. So what more do you think you would like to do? If you can just give us some sense of the type of properties or the magnitude, maybe just some big picture percent of the portfolio that you'd like to -- maybe over the next 2 or 3 years like to prune out?

[Todd Meredith, President & CEO]

Sure. I think what you see year in, year out is $50 million plus or minus in just sort of a regular course. And then, occasionally, like this year, you might have something that flexes that up. And I'd say, just in the last 2 or 3 years, we've certainly flexed that more to $50 million to $100 million. Beat that a little bit, a little ahead of that last year. So as you think about what we have going forward, I think that $50 million plus or minus is still a good way to think about it, but for some exceptional cases. The challenges, Kris, walked through in the disposition side is, you have to balance the fact that there's clearly some rotation in cap rate.

And I think Kris even emphasized the GAAP rotation versus just the cash rotation. So it's a balance of that. Obviously, an affordability of that and the reinvestment opportunities that you have. But year in, year out, we think $50 million, maybe up to $100 million is a comfortable range. If you kind of maybe use occupancy as a bit of a guide, we have about 95% of our properties that are just over 90% occupied. And that for a heavily multi-tenant portfolio is functionally full. And there is a wide distribution in there, but that's a solid level of occupancy. So you're kind of left with this 5% that kind of lives in this lower occupancy range and we articulate that somewhat in our repositioning group of properties that have that lower occupancy. So there's always that 5% that what we're looking at is, "hey, can we accelerate the leasing at these properties with some additional efforts beyond the normal course? Can we redevelop the property and stabilize the occupancy? Or do we just need to move on and sell the property?" So there's always that sort of 5% level that you're working through and trying to optimize. And even on the sales, you may not want to sell something at a certain point because the leases are about to expire and you want to renew those and extend the lease terms and put the best possible property out there for sale in the best shape you can. So it's a process. But $50 million to $100 million is probably the normal course.

[Vikram Malhotra, Morgan Stanley]

Okay, that's helpful. And then just a bit more -- can you give a bit more color on those sizable deals you mentioned. Just a sense of who those sellers are? Are they may be potentially sale leasebacks with hospitals or are they just private owners? And in relation to that, I know you said cap rates are tough to sort to peg, but can you give us a sense of where replacement costs are today across your major markets?

[Robert Hull, EVP, Investments]

Yes. On the portfolios out there, those are not hospital deals. One of them is a private owner and the other one is a physician-owned portfolio that's out there in the marketplace. Regarding replacement cost, I think if you look at -- depending on where you are in the country, whether you're in coastal market or somewhere in the Midwest, that's going to vary. We've seen it anywhere from $350 to $400 a foot, upwards of $600 to $700 a foot if you're on the West Coast. So we think that those are relatively stable replacement costs, but certainly have some differentiation depending on what market you're in.

[Todd Meredith, President & CEO]

Yes. The Seattle project that we have -- that we just started is probably more in the $400 to $500 a foot range, but it really doesn't bear the full cost of the garage. So to Robs' point, the full replacement cost out there in Seattle might be more in the $500 to even $700 range, depending on the density and situation you're building and the conditions and the complexity. If you have below-grade parking under a building, that's going to be more expensive. But really a big difference between markets. In the middle of the country, Nashville, it might be, as Rob said, $300 to $350. So it can be double in the coastal markets.

[Operator]

The next question comes from John Kim with BMO Capital Markets.

[John Kim, BMO Capital Markets]

This quarter, your FAD payout ratio is about 108%. You are expecting higher TIs. And it seems like that's going to be an ongoing circumstance over the next 3 years, just given half of your leases expiring over the next 3 years. So how do you climb out of this hole where you're not funding your dividend and have minimal free cash flow?

[Todd Meredith, President & CEO]

Well, the quarter certainly, as Kris walked through, had some temporary effects of a lot of the activities, whether it was the debt refinancing, the partial period acquisition. So I think looking at the fourth quarter only is a little extreme. And also, as Kris described, the CapEx -- the capital additions portion of that was just a bit of an anomaly in terms of the fact that it was high in the quarter. You really have to look at the whole year. And for '17, our FAD payout ratio was about 96%, still admittedly up there. So we're mindful of that. And I think, we're watching that closely to make sure we see where that is, pay attention to that. But looking ahead, in the years ahead, I think we're comfortable that we can continue to maintain that level and then slowly move in the right direction. So we're watching that very carefully and quarter-to-quarter, it could be a little over $100 million and then go the other way the next quarter. But we're looking, sort of, more of a -- on an annual basis on that.

[James Douglas, EVP & CFO]

I'll just add to that. As Todd mentioned, we had about $2.1 million or we expect about $2.1 million of additional NOI in the first quarter from the full quarter contribution of acquisitions from the fourth quarter. So if we had closed all those acquisitions in -- on October 1, then we would've had that in the fourth quarter, which would have put that payout ratio right at 100% even with the -- just the timing and elevated capital that we spent in the first quarter. So just looking at this 1 quarter, I think, doesn't give a good indication of where we are on our payout ratio and what we should expect looking into '18.

[John Kim, BMO Capital Markets]

What levers could you pull if it's sustained over 100%? Would you give up some rent increase and then lower TIs or have more single-tenant assets? Like what's on your...

[Todd Meredith, President & CEO]

No. I think what we're looking for is fundamentally organic growth in the relationship between this multi-tenant, same-store model driving that internal growth and then, obviously, being mindful of how much capital you're spending relative to that. Certainly, you're right. The mix matters a little and we're not saying from here -- whether you look at NOI and it's 80% multi-tenant, it's 80% NOI or 90% of square feet. We're not looking to dial that up to 100%. So we don't see a dramatic shift from here. A lot of what we sold in the last, call it, 15 months, 5 quarters, were these inpatient rehab facilities. So that had quite an impact on the shift. And so that shift will continue steadily, but not as dramatic as it did in '17. So we don't continue to see the same acceleration necessarily in that relationship. So that will certainly help getting kind of on plane and a steady course with a more concentrated multi-tenant mix that we can organically grow out of.

[John Kim, BMO Capital Markets]

Okay. And then on Page 22 of your supplemental, the contractual in-place escalators 2.69%. How does this compare to recent history? Because if I look at last supplemental, it looks like you disclosed that information on lease assigned. If I look back at 2015 supplemental, for instance, it looks like that was in-place and the numbers were higher. So I'm just wondering, how does the $2.6 million?

[Todd Meredith, President & CEO]

Yes. That's a good question.

[James Douglas, EVP & CFO]

Yes. Where to really look at it is at the top of the page there. We've given an 8-quarter history to see where it's gone. So the -- it's 2.69% blended for the full portfolio in the fourth quarter of '17. That's up from 2.5% in the fourth quarter of '16 and up from 2.47% in the first quarter of '16. So it has been making considerable improvements. A lot of it through the multi-tenant as well as some benefit from the single-tenant with [indiscernible] nonannual increases we've had recently. And then, we have more CPI associated with the single-tenant and that's ticked up a bit over the last several years as well, which has helped that average.

[Todd Meredith, President & CEO]

That's newer disclosure, I think this quarter is the first time that the top line there, that Kris just went through in the history, is exactly the same and ties to that very detailed table below. So it gives you that historical perspective. And you're right, it is different this quarter. And we've noticed that there was a discrepancy in the prior disclosure and wanted to give that history and tighten it up.

[James Douglas, EVP & CFO]

And the prior disclosure was giving you what the in-place lease -- the actual increases were for the leases that had an increase in the quarter, which is interesting information. But we think trying to look at where the direction of the overall portfolio, looking at the average of everything that you have in place is more meaningful. And that's the reason that we have changed and expanded this disclosure.

[John Kim, BMO Capital Markets]

Okay. And then finally, your purchase option this year, you disclosed about 13.6% cash yield. Your 10-K is saying that overall your purchase options -- the purchase price is 18% greater than your overall cost. So I'm just trying to marry those 2 items together.

[Todd Meredith, President & CEO]

Well, so you get a couple of different things. In that 10-K disclosure, you have a category of fair market value purchase options, which is -- it doesn't have this issue. This is just the fixed price, which is consistent with the one that we're talking about this year. I guess that number is that in that 18%...

[James Douglas, EVP & CFO]

Probably not. It's actually been pulled out since it's been...

[Todd Meredith, President & CEO]

That's all the remaining fixed purchase price options and how the price compares relative to our gross investment.

[Operator]

The next question comes from Michael Knott with Green Street Advisors.

[Andrew Suh, Green Street Advisors]

This is Andrew Suh filling in for Michael Knott. When we look at multi-tenant same-store performance, the margin seems to be slowly expanding and you've talked about revenue growth through occupancy gain, rate growth and cash leasing spread. But can you also talk about expense growth? What you guys are doing to contain expenses and whether you expect this margin to continue to expand?

[James Douglas, EVP & CFO]

Yes. In terms of expenses, it's a lot of blocking and tackling every day. And as you look at the distribution of your expenses, about 1/4 of it is taxes, which over time are going to go up. And you do your best to use consultants and control that growth. The other major item is core percentage of your utilities. And so we've done a lot of things in terms of energy management systems and things to help control our utility growth. And that really helped in '17. Overall '17 utilities grew close to 1%. And then, it's just across all the other line items that you have to stay on top of. But we think long term that being able to have operating expenses close to 2%, I think, for the year -- this year we ended up -- in the fourth quarter, it was slightly over that. That was related to some catch up on a couple of operating expense items. But long term, we think it's sustainable to be able to keep our operating expenses in that kind of plus or minus 2%. And if we can then maximize there on the revenue model closer to 3% or slightly over, that's what's giving us the operating leverage to expand that margin.

[Andrew Suh, Green Street Advisors]

Okay. And you guys have -- going into the year, you guys have 600 leases expiring about 16% of base revenue, which seems normal. But are there any leases that might be at risk or that we should be aware of?

[Todd Meredith, President & CEO]

No. We've put some disclosure in the K around just characterizing those leases, but it's predominantly -- just the whole portfolio is predominantly on campus with strong hospitals. So there's really in the multi-tenant portfolio, which is all I think that's expiring in '18 are very normal course and nothing of concern that we're aware of at this point.

[James Douglas, EVP & CFO]

One thing I'll add to that is we do have -- we have 1 sizable move out coming in the first quarter, but we've already backfilled the majority, I think 80% of that space. There may be some timing in terms of when one moves out and the other moves in, but that's within the overall expectation in averages for the year that, as Todd said, are not outside our historical norms.

[Todd Meredith, President & CEO]

And just to put it in perspective, in our world, where leases are smaller than most, it's a 36,000 square foot lease, which, for us, actually is large in our business. Obviously, nothing like some of the other healthcare space lease sizes. So -- again, we backfilled a lot of it, as Kris said, and there may be timing differences. But that's the only one we can think of at this point.

[Operator]

The next question comes from Tayo Okusanya with Jefferies.

[Omotayo Okusanya, Jefferies LLC]

I just wanted to make sure I fully understand the 3% to 4% NOI growth forecast for next year. So is the idea behind this -- at least from my math, it seems like very little occupancy gain, about 3% rent growth and about 2% OpEx growth. Is that the way you guys are kind of thinking about the world next year?

[Todd Meredith, President & CEO]

That's the normal course, you're right. That's the base business model. And then, to your point, occupancy and net absorption is what would then accelerate that to the top end of our guidance range for the multi-tenant properties. So again, the base model being mid-3s, a little over the mid-3% range if you walk through what you just described on revenue and expenses. And then from there, you accelerate with additional occupancy. And that's essentially what happened in 2017. We added -- we got to 4.9%, I guess, by adding the 30 basis points of absorption in the year on average. It's actually a little higher.

[James Douglas, EVP & CFO]

70 on average.

[Todd Meredith, President & CEO]

70 basis points on average in the same-store pool. So -- and obviously, absorption can have a big impact. So if you really strip that out, we were around 3.7% for the year, plus that absorption that took it to the 4.9%. So -- again, that range we provided allows for that on the multi-tenant side. It gets muted a little bit by the single tenant mix and that's what drives that 3% to 4% guidance.

[James Douglas, EVP & CFO]

And Tayo, if you look at Page 25 of our investor presentation, it walks through, kind of, the multi-tenant revenue model and some of those specifics that Todd just mentioned.

[Omotayo Okusanya, Jefferies LLC]

How are you feeling about net absorption in 2018, just kind of given underlying fundamentals still seem to be very strong, I guess?

[Todd Meredith, President & CEO]

Yes. I mean, it's certainly something we're very focused on. And if you look at last year, for the same-store portfolio, and this is period-end -- I'll go to period-end occupancy, just kind of net absorption for the year. It was about 30 basis points for '17. And then if you look at '16, it was very similar, about 25 basis points. And so as a baseline, that's a very reasonable assumption and that's certainly something we're looking to try to achieve in '18. But I do want to be careful that, that is not something where you see 1%, 2% a year, unless there's something unusual going on, so major absorption in some specific assets. But for a portfolio like we have, it's 160 something properties, 170 properties in same-store, moving 25, 30, 40 basis points is significant. So we've got room for that in our range in our guidance in '18 and that's not unreasonable to assume.

[Omotayo Okusanya, Jefferies LLC]

Got you. That's helpful. And then just going back to the dividend. Again, just kind of given where the current FAD payout is, you try to grow into it, is it safe to assume that you don't really expect any dividend increase in 2018 as well?

[Todd Meredith, President & CEO]

Well, we obviously evaluate that every year. And if you look at the end of 2017, we're at 96%. So certainly, we're headed in the right direction. But we want to be careful about that. We don't want to do it too early and we don't want to do it in a haphazard way. We want to do it where it's something that can be safe and reliable and consistent in the future. So it's -- we're headed in the right direction on that. It's something we'll evaluate each year as we make progress. So it's -- whether or not we do that in 2018, obviously, we'll have to look at where we are relative to the 96% we are in '17.

[Operator]

The next question comes from Todd Stender with Wells Fargo.

[Todd Stender, Wells Fargo Securities]

And I know you guys don't give earnings guidance, but just wanted to see if we can hear some of your updated thoughts maybe for 2018. Your earnings appear static and dividend payout that John had highlighted doesn't screen well. But you did have that equity raise in inpatient rehab sales in 2017, so you might have some overhang from some of those dilutive proceeds but you had heavy Q4 investment volumes. So anything you can share for 2018, just give us comfort that we should see a little bit more growth?

[James Douglas, EVP & CFO]

Yes. Todd, I talked about in my prepared remarks and we -- that we did not have the full quarter contribution from the acquisitions that we closed in the fourth quarter. So that in itself is about $2.1 million that should flow through in the first quarter. So that will certainly help. And as you mentioned, if you're looking at '17 over '16, we had the rotation that occurred in '17 that I talked about moving out of the inpatient rehabs and the cap rate rotation. We also had the equity and the timing of that equity that we did in August and then really redeploying those proceeds through the end of the year, which also created some timing impacts. The other thing I think people need to keep in mind is that we also had about $95 million of dispositions in our '16 results.

[Robert Hull, EVP, Investments]

Fourth quarter.

[James Douglas, EVP & CFO]

Yes, in the fourth quarter of '16. So we kind of had the reverse in '17 that we had in '16. And in '16, we were front-loaded on acquisitions and back loaded on dispositions. Wherein '17, we were front-loaded on dispositions and back loaded on acquisitions. And so that's going to have an impact on the timing and the overall FFO growth. But as we're looking -- moving into '18 with now having all those acquisitions closed in the fourth quarter, I think we're positioned well for growth going forward. Obviously, there are -- we do have the timing -- the headwind of the purchase option that will be in April. So you can't overlook that. But just -- in general, from being positioned off of all the activities that we competed in '17, I think we're in a really good shape.

[Todd Meredith, President & CEO]

And on the acquisition timing for '18, obviously, we're still working on a number of things in the pipeline that Rob articulated, but I don't -- we don't necessarily see a major timing issue with that purchase option in April and being able to get those proceeds to work fairly quickly. So to Kris' point about timing, dispositions versus acquisitions, we should see a little better result on that front in '18.

[Operator]

[Operator Instructions]. The next question comes from Eric Fleming with SunTrust.

[Eric Fleming, SunTrust Robinson Humphrey]

Just had a quick question on development spreads. You guys are saying you're running -- looking at '18 of 100 to 150 basis points. One of your peers is talking about being a bit more progressive on development in that 50 to 100 basis point spread. Do you guys see any further pressure on development going forward or is it more just your relationships keep it where you guys have it?

[Robert Hull, EVP, Investments]

Yes. I mean, I think developments -- you just can't turn development on overnight. I mean, I think -- we've [indiscernible] out there talking to our hospital partners and managing our existing relationships. Last year, we had $76 million in development starts. We've given guidance this year of $50 million to $100 million. We think that's a reasonable pace, given our investment strategy and our selective strategy of investing on-campus or adjacent to campuses. We could be -- if we saw some opportunities out there that presented themselves, we would be more comfortable with a little bit more than that. But we certainly won't sacrifice our quality standards to get more volume.

[Todd Meredith, President & CEO]

And I think what you're seeing mostly with maybe that more aggressive position is a little different profile than what they might be looking to develop. So they may be looking at something that's either fully leased from the get-go, maybe single-tenant and they've got this [indiscernible] tenant approach to it versus -- and it maybe -- I don't know whether they are off -- looking at off campus or on. But we tend to, as Rob described, look at something that's more hospital-relationship driven. And the case of the one in Seattle is a good example where we started the project at 44% leased, and quickly, it's gone to 60% leased. And we have very good indications for leasing it up. And it won't be done until the second quarter of '19. So that's a profile that fits us more. It's kind of a relationship deal where we're working with them to fill out their outpatient expansion needs rather than just someone coming out in our [indiscernible] and say we need a building, it's full. That's really in our mind a forward acquisition, just taking some risk on capital and timing. And we like something that's a little bit more true ground up, multi-tenant development. And that's just a little bit different profile.

[Operator]

This concludes our question-and-answer session. I would like to turn the conference back over to Todd Meredith for any closing remarks.

[Todd Meredith, President & CEO]

All right. Thank you, Phil. That concludes our prepared -- excuse me, thank you everybody for joining this morning. We appreciate it. We'll be around today and tomorrow for follow up, and we hope everybody has a great day. Thank you.

[Operator]

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.