Healthpeak Properties Inc (DOC) 2022 Q4 法說會逐字稿

Greetings, and welcome to the Physicians Realty Trusts Fourth Quarter 2022 Earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Brad Page. Thank you, Mr. Page, you may begin.

Thank you, Maria. Good morning, and welcome to the Physicians Realty Trust Fourth Quarter 2022 Earnings Conference Call and Webcast. Joining me today are John Thomas, Chief Executive Officer, Jeff Theiler, Chief Financial Officer, Deeni Taylor, Chief Investment Officer, Mark Theine, Executive Vice President, Asset Management, John Lucey, Chief Accounting and Administrative Officer; Laurie Becker, Senior Vice President, Controller and Dan Klein, Deputy Chief Investment Officer.

During this call, John Thomas will provide a summary of the company's activities and performance for the fourth quarter of 2022 and our year-to-date performance in 2023 as well as our strategic focus for the remainder of 2023. Jeff Theiler will review our financial results for the fourth quarter of 2022, and Mark Theine will provide a summary of our operations for the fourth quarter. Today's call will contain forward-looking statements made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. They reflect the views of management regarding current expectations and projections about future events and are based on information currently available to us. These forward-looking statements are not guarantees of future performance and involve numerous risks and uncertainties. You should not rely on them as predictions of future events. Our forward-looking statements depend on assumptions, data methods that may be incorrect or imprecise, and we may not be able to realize them. We do not guarantee that the transactions of events described will happen as described or that they will happen at all. For a more detailed description of risks and other important factors that could cause our actual results to differ from those contained in any forward-looking statements, please refer to our filings with the Securities and Exchange Commission.

With that, I'd now like to turn the call over to the company's CEO, John Thomas. John?

Thank you, Brad. Physicians Realty Trust demonstrated resilience throughout 2022 and enters 2023 from a position of strength. Our assets are performing well. Demand for our space remains strong, and our balance sheet is well positioned for outsized external growth. We're proud of our achievements during the year, including attainment of the highest annual FAD, funds available for distribution, per share in the history of the company. The cash growth is supported by record leasing performance. For the year, we executed leases totaling more than 1 million rentable square feet, including over 800,000 feet of renewals at an average spread of 6%. Retention remained strong at 77%, and more than 60% of our executed leases had an average annual escalator of 3% or greater.

We remain focused on creating long-term value on behalf of our shareholders. This can occasionally require the selective nonrenewal of leases and we believe that the space can be relet to stronger health system tenants. While this has the effect of hurting total occupancy and same-store NOI growth in the short term, we believe that these decisions result in a stronger portfolio that delivers superior cash flow growth in the future. During 2022, we increased the amount of space leased to investment-grade quality tenants from 65% to almost 67%, and we believe that we continue to have the highest portfolio lease rate of any public medical office building investor.

The rapidly changing interest rate environment required us to be disciplined when evaluating external growth opportunities during 2022. Still, we were able to add value to shareholders through the transactions we did choose to pursue. In July, we opportunistically sold disposed of our three Great Falls, Montana medical facilities at a 4.7% cap rate, generating a $54 million game and an outstanding 16% unlevered IRR. We matched this transaction with a $160 million of new investments in 2022, highlighted by our $82 million acquisition of the Calko Medical Center in Brooklyn, New York at a 5.5% stabilized cash yield.

We also continue to work with several health systems to move development and redevelopment projects forward that we expect to proceed in 2023 and generate rent in 2024. Our financial achievements were matched by our accomplishments as they relate to corporate responsibility in 2022. We made measurable progress toward our goal to being a sustainability leader across all real estate industry sectors. For the year, we invested in 31 projects totaling $5.6 million that will directly reduce the energy footprint of our facilities, while also enhancing the desirability of these assets to tenants. Thoughtful investments like these are a critical part of our long-term sustainability objectives, including our goal announced in 2021 to reduce our portfolio's greenhouse gas emissions by 40% by 2030 over our 2018 baseline. Social accomplishments in 2022 include 902 hours of volunteer work individually and corporately to the communities we serve, which exceeded our 600 hour goal by over 50%.

DOC also provided more than $408,000 to philanthropic fundraising and in-kind donations to community and health care provider organizations, benefiting their research and mission initiatives. In addition, in 2022, we earned recognition for modern health care as one of the best places to work in health care for the second year in a row and top workplaces honors from the Milwaukee Journal Sentinel in our headquarters for the fifth year in a row.

Our ESG efforts continue to receive recognition at asset and corporate levels. During 2022, 10 DOC assets were certified by IREM under the Certified Sustainable Property Program, bringing our aggregate count to 38 properties with this designation. Separately, we earned 16 new ENERGY STAR property certifications under their recently relaunched medical office building program, bringing our certification count to 26 and qualifying DOC as a premier member of the certification nation's efforts.

We're also proud to share that we were named to Bloomberg's Gender Equity Index in January of 2023 as a first-time submitter, distinguishing our work in gender equity and enhance public disclosure. We're thankful to have been recognized in each of these ways and remain committed to maintaining our status as a leader within the health care REIT sector on matters of ESG.

In a few minutes, Jeff will discuss the strength of our balance sheet, and Mark Theine will provide more details on our operating results. Before that, I'd like to take a moment to speak toward our expectations for the year ahead. In 2023, we have set ambitious goals to increase our occupancy at market rates and continue seeking medical office acquisitions and development opportunities. Our development financing pipeline is more extensive than ever with more than $200 million at cost of opportunities under evaluation and exclusive negotiation. We expect to proceed with many of these opportunities and are targeting stabilized project yields in the 7% to 8% range. The acquisition market has not yet stabilized with current capital market conditions. On market transactions are working around the high 6 cap rate, still with low volumes and a limited financing market, we do not believe the market has reached equilibrium with our weighted average cost of capital or the market's cost of capital generally.

In conclusion, Physicians Realty Trust enters 2023 with a strong, stable and proven portfolio. Our balance sheet is strong, and we remain disciplined in capital deployment, patiently waiting for acquisition and development opportunities that will be accretive to our long-term financial goals. We celebrated our 10th anniversary this summer, and we are proud that we have built this company to last for decades to come. I will now turn the discussion over to Jeff. Jeff?

Thank you, John. In the fourth quarter of 2022, the company generated normalized funds from operations of $61.5 million or $0.26 per share. Our normalized funds available for distribution were $57.9 million, an increase of 5.4% over the comparable quarter of last year, and our FAD per share was $0.24. In 2022, our normalized FAD was $242 million, an increase of 10.6% over 2021 and our full year FAD per share was $1.01. Re-leasing spreads remained strong this quarter at 7%, and we expect the broader economic environment to support our efforts to roll the portfolio's rent up over time.

On the expense side, we're protected from stubbornly high inflation by our standard triple-net lease structure in which we recover 84% of all operating expenses, which is about 20 percentage points higher than our peer group. While year-over-year same-store NOI growth was below expectations at 1.5% due to the move-outs discussed earlier in the year, we see positive results on a sequential basis with quarter-over-quarter same-store NOI growing by 1.3%. On the acquisitions front, we had projected minimal acquisition activity in the fourth quarter and saw that play out with just a handful of strategic transactions taking place, along with some funding on existing loans. Patience continues to be the theme here.

While cap rates have drifted significantly higher, we are not yet seeing a high volume of deals that meet our quality thresholds at pricing that makes sense in this capital environment. Our cost of capital is extremely competitive right now, so it isn't that we are competing against cheaper capital. Instead, we see this as the usual delay that happens when sellers have to adjust to pricing that is less advantageous than they could have received several months ago. Therefore, we are reluctant to put out acquisition guidance at this time. We believe that either cap rates will adjust to historical norms based on current debt costs or we will see improvements in our cost of capital that will create opportunities in the current market environment. We are in constant dialogue with potential sellers and health system partners and believe we will be in an excellent position to grow the company's earnings substantially when this bid-ask spread closes.

We took steps to bolster our balance sheet further by issuing $74 million of equity in the fourth quarter on the ATM, along with another $66 million on the ATM in January. This places our balance sheet on a debt-to-EBITDA run rate of 5.2x on a consolidated basis and provides plenty of dry powder for us to utilize at the right time.

Finally, a few updates to our 2023 guidance. We expect G&A to increase by about 4.5% at the midpoint to a range of $41 million to $43 million. Recurring capital expenditures are expected to increase modestly by about 5% at the midpoint to a range of $24 million to $26 million as we continue to see tenants trade TI dollars for lower renewal spreads. As mentioned earlier, acquisition guidance will be withheld until we have more visibility on how cap rates and capital costs evolve in 2023.

With that, I'll turn it over to Mark to walk through some additional operational details. Mark?

Thanks, Jeff. Our tenured asset management, leasing and capital project teams are united in our focus to serve our health care partners while growing cash flow for our stakeholders. We contributed to these goals in 2022 by delivering record renewal spreads, maintaining retention and efficiently prioritizing capital project investments in this inflationary environment. These successes are the direct results of our commitment to outstanding customer service and in line with our care core values.

Despite the difficult macro environment, we delivered record full year renewal spreads of 6% while maintaining retention of 77%. Importantly, these results were achieved without offering excessive incentives with full year renewal TIs totaling just $0.80 per square foot per year. This efficiency was matched by our capital projects team who deployed $23.9 million of recurring CapEx in 2022, representing $1.48 per square foot.

During the fourth quarter, we continued our positive momentum by achieving renewal spreads of 7% on 141,000 square feet of volume with leasing costs totaling $0.45 per square foot per year. In addition, new leases totaling 42,000 square feet commenced during the quarter at an average rate of $18.64. Tenant improvement costs on new leases totaling $3.89 per square foot per year remained well within industry averages, demonstrating our commitment to bottom line effective rent rather than headline rate.

The weighted average annual rent escalator on this quarter's 182,000 square feet of leasing totaled 2.9%, a significant increase against the portfolio average of 2.4%. MOB same-store NOI growth was 1.5% in the fourth quarter, below our historical 2% to 3% growth rate due to the 30 basis point decline in occupancy from the vacancies we discussed last quarter. In total, this 51,000 square feet of lost occupancy across 13.5 million square foot same-store portfolio is largely explained by activity at two specific buildings. First, same-store occupancy continues to be impacted by the strategic nonrenewal of suites and an MOB in Minnesota to allow for the construction of a brand-new ASC that is currently under construction and leased to the dominant investment-grade health system in the market. The new 21,000 square foot surgery center is expected to be completed and paying rent during the third quarter of 2023.

Second, 22,000 square feet of vacancy is attributable to an MOB in Pennsylvania, where our historical physician tenants were employed by a hospital and relocated to the hospital's owned medical office facility at the end of the lease term. We are making several investments to improve this space, and we have partnered with the local brokerage team with strong health care relationships.

Overall, we do not view the small amount of negative net absorption to be indicative of market conditions or our potential for internal growth, but rather one-off events that will have a short-term impact on the portfolio. Excluding these two assets, MOB same-store NOI growth would have been 2%. While we don't typically highlight our sequential same-store results, the 1.3% growth in NOI, stable occupancy and 0.5% reduction in operating expenses show positive progress in the impact of our team's efforts. This is our 19th consecutive quarter of positive same-store NOI cash growth.

Again, we entered 2023 with strong leasing momentum. The macro leasing environment continues to offer an advantage to existing medical office inventory, with quality space and move in condition due to the cost and time required for new construction, especially in markets like Phoenix, Nashville, Atlanta and Dallas where DOC has a strong presence.

At the beginning of the year, our leasing and marketing teams launched a comprehensive campaign to increase online exposure of our properties, target key brokers and market influencers and leverage the relationships and knowledge of our in-house property management team. Just two months into the year, our efforts are already yielding results as tours of vacant space are up nearly 30% year-over-year, and we are trading proposals on over 162,000 square feet of vacant space in the portfolio. Our leasing and property management teams have a busy calendar of broker open houses to showcase our portfolio and demonstrate new virtual reality technology, which allows prospective tenants to visualize a customized suite and finishes before commencing expensive construction.

We have dedicated approximately 60% of our 2023 recurring capital budget of $24 million to $26 million to leasing initiatives that include renovating vacant suites, tenant improvement allowance us to retain and attract health care providers and general building renovations where there's a strong leasing activity due to the supply and demand of physicians in the market. Through these collective efforts, we believe there is opportunity for an increase in total portfolio occupancy in the back half of the year, following a typical three to six months it takes to design, construct and commence the new lease. We expect this positive momentum to also appear in lease renewals. While 2023 scheduled exploration volume remained small at 4.5% of the consolidated portfolio, the market conditions that helped contribute to our success in 2022 remain intact. For the full year, we expect renewal spreads to be in the mid-single digits compared to the long-term MOB industry expectations of 2% to 3%, and we anticipate retention to be in line with our historical average of 75%.

To conclude, we anticipate that our operational initiatives will lead to improved same-store NOI growth beginning in the third quarter of 2023. While below target same-store performance is frustrating in the short term, we believe that long-term value is maximized through thoughtful portfolio management, intelligent capital investments and aggressive leasing initiatives. The thesis for medical office is as strong as ever, and we're excited to execute on behalf of our stakeholders in 2023. With that, I'll turn the call back over to John.

Thank you, Mark. Maria, we're now ready for questions.

We will now be conducting a question-and-answer session. (Operator Instructions.] Our first question comes from Juan Sanabria with BMO Capital Markets.

Just hoping to talk a little bit more about the leasing efforts and the occupancy upside. Can you kind of quantify how much occupancy upside you expect? I think you said in the back half of the year? And would that really be driven by filling current vacancy? Or is it more incremental new leasing of space that has been sitting vacant for a bit. And given the -- you kind of give the piece parts of re-leasing spreads and occupancy a bit, what is the expectations for same-store NOI for 2023?

Juan, thanks a lot. This is JT. I think our ambitious goals this year are around both vacancy and really kind of non-renewing lower quality credit tenants with higher quality health system tenants who need to expand in the space and their buildings. So, it's 95% to 96% is somewhere in that number is full occupancy. And so our ambitious goals has kind of hit those numbers, and so positive accretion for the year. And our compensation goals are tied to that as well. So we're -- we think that's very achievable somewhere in that range. And same-store is a number that is impacted by a small percentage, very small percentage, of move out, some of which we caused on our own in sequential quarters. And it takes a couple of more quarters to backfill that space with both leases signed, but also, more importantly, kind of completing the TI and the commencement of those leases.

So back half of the year, we have high expectations for good solid kind of return to our same-store growth numbers that are historical. First half of the year, we're kind of burdened by the kind of decisions we made, we think, the right decisions in the third and fourth quarter of 2022.

Okay. And then I was just hoping for some color on the transactions market and kind of where you see the bid-ask spreads, maybe in terms of cap rates of where dollars are still holding on and what you think is realistic given your capital costs are generally higher capital across the market?

Yes. Great question. And we're seeing a significant movement in cap rates. There are just not many transactions occurring. Sellers are just holding on hopeful that we've returned to the glory days of 2020 and 2019 from a cap rate perspective. But transactions are occurring in the mid-6s. We think we have a great cost of capital in the current environment, but that cost of capital still expects, needs, kind of high 6s to mid-7s kind of cap rates depending upon the annual increases and the rents and things like that to execute. So, we think there's a good opportunity in the back half of the year, assuming that kind of the market reaches equilibrium in that range. But in the current environment, we're just not seeing many trades that right quality, right credit, right location that we want to buy kind of in the mid-6s. So, we want to get -- we want to see those cap rates move up. And like Jeff said, we've got a balance sheet loaded to execute once those we reach equilibrium, is my word, in cap rates with market cost of capital.

Our next question comes from Josh Dennerlein with Bank of America.

Just wanted to follow up on some of your opening remarks on the lease escalators. I think you said you ? for you just signed in 4Q, I think, 2.9%, up from 2.4% in the in-place portfolio. I guess how are the current conversations going for the leases renewing in 2023? Are you able to push a little bit more aggressively on the go-forward leases?

Josh, great question. That's one of the things that just kind of understated in our comments. Josh, what I was saying was I think 60% or more of our leases in the fourth quarter, we renewed with average annual increases over 3% or 3% or more. And the compounding effect of that is probably the best thing we can do in our leases and just moving our kind of average annual escalator up from 2.4%. I think we're up to 2.5% now, and we continue to move that up. So those conversations continue to be strong, and we continue to have kind of some negotiating power in the average annual increasers to move those up beyond historical averages. And our leasing team led by Amy Hall and her team are doing a great job kind of focus on not only the renewal rate, which, again, for last year was 6% or more but also that average annual increaser. So, we try to get CPI and we can try to get floors in that CPI increaser but just moving that number up as a long-term compounding effect.

We don't sign 1 night leases or 30-day leases or even one-year leases. We sign five years or more leases and extensions on existing leases and that average increaser is a really important part of our strategy to grow NOI over the time.

Okay. Appreciate that color. And then maybe one big picture question for me. Any kind of like changes you're seeing with health systems in the current environment kind of coming out of COVID? I know they did have some labor pressures, just some challenges on that front. Like anything they're looking to do differently that might help your business or hurt it a little bit? Just trying to get a sense of the landscape.

Yes. Since 1982, there's been a push by Medicare and payers to move more care out of the hospital into outpatient settings. And I think health systems realized during COVID, they don't have enough outpatient space available for the kind of demand in their markets. And so, what we're seeing differently from health systems is a more intensive strategy to open new outpatient locations in strong demographic locations, and that's what's leading to a lot of development opportunities for us. All health systems, investment-grade and otherwise, had challenges in 2022 with inflation and labor shortages and stress of labor and things like that. We're starting to see that stabilize. And the revenue side or the reimbursement side of health care is always a lagging indicator, not a lagging indicator, lagging impact on their P&L statements. And so, expenses are real-time, revenue, reimbursement rates take time to catch up with inflationary pressures. And so, we're starting to see stability there, but at the same time, reimbursement increase or kind of catch up with inflation. So, lots of ways to go, but the U.S. health care economy this year is going to be $3.5 trillion. So there's lots of money in the system, lots of intensive efforts to move more care to the outpatient setting, which is more profitable and at the same time, some stability in the labor market.

Our next question comes from Omotayo Okusanya with Credit Suisse.

Question on internal growth. I think everything that's happening on the top line is pretty impressive even with some of the deliberate occupancy drag. But with OpEx, I think, again, your same-store OpEx growth was 9.8%. Could you just talk a little bit about efforts to kind of mitigate some of the OpEx increases going forward? And specifically, is part of that just because of, again, your triple net leases, but not everything is passed through at this point. Jeff, I believe you mentioned you have like an 84% reimbursement rate. Could you just talk a little bit about how ultimately some of the OpEx growth gets mitigated going forward for better same-store NOI growth performance?

Yes. Thank you Omotayo. I'm going to ask Mark to respond to that.

So as you point out, our operating expenses in the fourth quarter were up 9.8%. That's definitely higher than historical norms. But one thing kind of below the surface that's really pushing it up this quarter is some onetime insurance costs, our insurance in the quarter was up $1.2 million over the prior year. And again, those were some onetime costs in the quarter. But one of the things we really appreciate about our portfolio, as Jeff alluded to, is that we're 95% occupied and highly triple net leased. So, our operating expense recoveries were actually up 10.3% to offset that increase.

What our asset management team is really focused on is controllable expenses and where we've got the ability to impact long term, the operating expenses of the portfolio. And if you look specifically at controllable operating expenses in the quarter, those were up about 5%, 5.5%. So that's a pretty good run rate and great work by our asset management team in this inflationary environment to really focus on those controllable expenses, which excludes insurance and taxes.

That's helpful. And then the continued investment in real estate technology, I think you guys put like $0.5 million into that again this year, this quarter. Could you just talk a little bit about, again, the ultimate return on investment that you're looking for? How this is going to help you guys in lower operating expenses. Just again, as you just kind of look at more investments on the technology side, what exactly do you kind of expect to get out of that?

Tayo, this is Jeff. Good question. So, look, we think we'll get a good return out of that investment just on a monetary basis. But really, the investment is also designed to help us stay in front of the latest technology, the latest real estate technology. And to your point, I mean, help us manage our operating expenses going forward. So we think it is going to be a good return on the investment side, but it also gives us front row access to all these new companies that are coming out with innovative real estate solutions and really helps us be at the forefront of having the best possible management of our properties and keep our operating expenses low for our tenants and which, of course, helps the company itself.

Are you partnering with any of those companies at this point and seeing any kind of results?

Tayo, it?s JT. I think part of the opportunity in this PropTech investment we made is to work with other REITs to kind of identify and benefit from kind of the best IT minds out there. So, I don't think our shareholders are looking for us to create our own IT platform. I think the benefit is we're investing alongside other REITs and other institutional real estate owners to kind of develop IT tools that we will benefit from. And at the same time, have a great IRR or return on investment from that direct investment. So we haven't seen anything directly, but we get to explore these tools, which is part of the opportunity that are under development or that are kind of leading-edge technologies. So, we'll see some long-term benefits eventually.

Great. And then one more for me, if you can indulge me just a capital allocation question. So, some of the recent equity issuances, again, what's again, are going to be the use of the funds, especially just kind of given the issuance that your current kind of implied cap rate? And lastly, how do we think about the dividend outlook going forward, given like the 96% AFFO payout ratio?

Yes, Jeff?

Yes, I'd be happy to. So yes, we did some equity issuance on the ATM. We're trading at an implied cap rate in the mid-6% range. That's consistent with where we've seen Class A medical office buildings being marketed. We haven't seen many transactions closing still and cap rates have really only been moving in one direction, which is up. So we thought it was prudent to strengthen our balance sheet at these levels, which we think is going to give us a great opportunity when the market stabilizes at what we think the right numbers are to really be an active investor and to really generate strong earnings accretion, which is certainly a departure from the previous times when cap rates were so low, it's hard to generate earnings accretion. We think we're going to be able to get best-in-class Class A MOBs at really good pricing. So, we feel good about the strengthening of the balance sheet. Obviously, in the meantime, it also pays down our variable rate debt, which is -- also seems to be only moving in one direction, which is higher with the Fed's increases. So, we think it's a smart capital allocation decision.

Our next question comes from Michael Griffin with Citi.

Maybe to follow up on Tayo's last question there related to the equity issuance. I mean you talked about being disciplined in 2022, patients continues to be a theme. You mentioned a competitive cost of capital. Why the equity issuance now, I guess, just given the sense that it's at a pretty notable discount to what consensus NAV is at. You seem like you're fine from a balance sheet perspective. It seems like the capital markets are going to be pretty muted for the near term. Why did it make sense now? And why not maybe put it off for until capital markets activity improves?

Yes. Mike, I'll take that. Look, I think we're running at the low end of our leverage range, right, which we've put our leverage range out at 5.5% to 6%. Certainly, one can argue that the capital markets have been very choppy over the last few months. I mean, certainly, we've had a good month in the capital markets overall or good year-to-date, I should say. But that's not guaranteed by any stretch. So really, the idea is it's kind of a -- it's not a discount to where we're trading on an implied cap rate versus where we would be buying assets today if they were closing. So, I think it makes sense to have that optionality to kind of build that dry powder now such that if the capital markets frees up for some reason, we're still going to be in a position to grow and grow when others can't.

Right. So, it seems that in your view, it's relative on an implied cap rate basis, maybe investors should be thinking about it on that basis relative to premium or discount to NAV. Am I reading that correctly?

Yes, I think that -- I mean they go hand in hand, right? But yes, I think that's how we're thinking about it. Our implied cap rate versus where assets are trading and are being marketed right now, I should say.

Okay, cool. And then maybe one for Mark. I know you talked about selective nonrenewal of certain leases. You mentioned the MOBs in Minnesota and Pennsylvania as examples. I get the long-term strategic rationale behind this, but I just want to clarify, is there any potential for additional strategic non-renewals that could impact occupancy in 2023? And any additional color around that would be helpful.

Yes, sure, Mike. So again, we strategically did not renew two leases to -- in Minnesota to bring in an investment-grade tenant. So that's going to create great long-term value for the company, for the portfolio for shareholders. And we're going to continue to look at opportunities always to replace existing tenants with investment-grade quality, great long-term tenants. So, it does create a near-term drag on our same-store results, which is frustrating, but it provides the right long-term value. And we will always look for those opportunities in 2023 and years after that. So the good news is our leasing team has done a fantastic job this year of already commencing conversations on 162,000 square feet of new leases on vacant space. Now not all of that will get done. But those are good conversations to start the year, and we feel good about filling vacant spaces throughout 2023 and really growing our net absorption.

Our next question comes from Ronald Kamdem with Morgan Stanley.

Just two quick ones. Staying on the balance sheet. So, if I look at the $66 million, plus or minus, equity issuance post Q. Just trying to get a sense of what that was put towards and sort of the related question to that is, so if I annualize your interest costs in 4Q, I get to sort of an $80 million number. Is that sort of the right ballpark or did some debt get paid down? Hopefully, that makes sense.

It does. Ronald, it's Jeff. So yes, we put that towards paying down the revolving line of credit. So obviously, we expect eventually to redeploy those proceeds into acquisitions. But in the meantime, we paid down the line of credit with it, so it will bring the interest expense down a bit.

Got it. And then just on the acquisition, I know you guys are not providing guidance, given sort of what you've talked about. Can you talk a little bit more about just what the competition is? Like why are cap rates staying so tight, who's sort of stepping up and still buying here? And why haven't we seen sort of more widening?

Yes, it's JT. I think it's just a sellers holding out and hoping. So eventually hope conflicts with rising interest rates on short-term loans that were used to acquire four-cap, five-cap assets in the 2017 to 2020 range. But I think until we see kind of more distress on the ownership side or the capital side, medical office billings, we won't see a lot of trades occurring. So, it's moving in the right direction. It just takes time for the market to kind of rationalize between cost of capital and it's been a 20-year bull run and in medical office, in the 10-year treasury and kind of other things. So it just takes time for the -- when interest rates rise 400, 500 basis points like they have in the last six to nine months, it just takes time for the kind of the market to reconcile itself. So, it will get there. And we expect a pretty good back half of the year, but the market's got to get there.

Your next question comes from Michael Carroll with RBC.

JT, just staying on the MOB private market valuations, I think you highlighted that assets were being marketed in the mid-6% cap rate range right now. Is that a fair valuation? Or do you think it needs to go higher from that mid-6 type cap rate?

Yes, Mike, great question. I think that's -- when they're marketed at that rate, almost by definition, that means that the price should be better from a -- should move up from that range. And so frankly, the fact that assets are even marketed above 6% is a dramatic change from where they were marketed six months ago, and they still need to move a little higher. So, we're waiting patiently. We're not out of the market as far as exploring opportunities. But when we make an offer on a Class A asset that we're really excited about, it's going to be higher than mid-6s.

So, we're thinking more of like a high 6%. Are we talking about 7% type range? Or I guess like mid-6 is obviously a pretty wide range. I mean, are we talking higher than that?

Yes, generally, we're IRR investors. So, it depends on the annual increases, where they are in market rents and things like that. So, it's a combination of factors. But from a cap rate perspective, just the market generally is -- we're seeing trades, very few, but we are seeing trades in the mid-6s on assets that if they were trading at, let's just call it, 7, we would be pretty excited about moving in the right direction. So, it's just few and far between, but we think the market is moving in the right direction as a buyer in a long-term investor.

Okay. And what's the appropriate IRR target? I mean trying to translate this from a cap rate to an IRR? I mean, are we talking about 8%-plus IRRs?

Yes. I think that's a fair way to think about it.

Okay. And then are these high-quality MOBs, so like off-campus affiliated with the major health system. Is that what we're generally talking about here?

Yes. And we're very transparent. That's all we buy. And so that's what we're talking about. So, you can get lower quality. You can get lower quality at a higher rate. You can do other asset classes at a higher rate. But right now, for Class A assets. And I think in part, that's where we see development kind of leading the way over the next several years as health systems really are looking for new strategic locations, and we're working with several right now on kind of helping them develop those locations and get in a more attractive yield in the current cost of capital environment.

Okay. And then I know earlier in your prepared remarks and through some of these questions, you talked about selectively not renewing some tenants if you think that there's a better tenant that could take that space. I mean are we talking about some of the things that you already did? Or are there additional leases that you plan on doing this with in 2023?

It's a great question. So, it was about -- we have 16 million square feet, and we're talking about 40,000 square feet where we did that last year, and we're already backfilling that space. It just takes time for the new leases to commence post TI. There'll be a little bit of that in the first quarter this year, but it's -- when the tenant has too much space, I mean, that's almost worse than having the tenant kind of renew a lease and occupy space that we think there's a better market rates for out there for -- to compete for that space. So we have a little bit of that in the first quarter this year, but it's not a lot across 16 million square feet. But short term, it's negative. -- long term is very beneficial to the company.

Our next question comes from Dave Rodgers with Baird.

Just a couple of follow-ups on investments. I think the first would be around the development funding pipeline, $200 million that you talked about. I think this was a similar number to where you started last year. Maybe give us a sense of kind of how it kind of wound up in 2022 versus that expectation. I think it's probably lower, but just give us your own assessment of that. And then, I guess, what gives you confidence in that number for this year and the debt markets may be part of that. The second would be maybe a follow-up to Mike's question just a minute ago. In terms of the investment activity that you expect to accelerate in the second half, is that because you're seeing more RFPs on the market more packages coming out? Is it more hope or you're actually seeing a good amount of activity that would lead you to be able to close activity or close acquisitions in the second half of the year?

Dave, those are all great questions. Hope is not a strategy. We don't depend upon RFPs to find assets or work with health systems. Those tend to be auction-type processes where there's always some low bidder that you don't want to compete with, not that we couldn't. And so, I think the $200 million is active discussions with health systems. Last year, when both supply chain and inflation was going up, you couldn't get a construction contractor to give you a quote on a contract to build a building that was good for more than a day. I mean historically, you'd get a bid and 90 days later, 180 days later, it was still a good number.

So last year, a lot of the projects that we're working on are still there, and that's the confidence in that $200 million number is some of those projects that are carrying over. And we're just -- we, the health system, the physicians, we're waiting on some stability, stabilization in the construction and also the time line with supply chain and other things that are kind of beyond everybody's control. And so, numbers are coming in today. We're proceeding with some projects that we thought we would begin construction in the fourth quarter. But the tenant, the capital, us, the contractors all have more stability today than we had three months ago. And frankly, that's going to create much more long-term value for us by that short delay on those projects. So we'll be breaking ground in the next 30 days on projects that we've been working on for a couple of years. So, we feel really confident in that number going forward, and we see a lot of more opportunity in that space.

The next question comes from Steven Valiquette with Barclays.

So, I guess not to get too granular on the same-store OpEx that was up 9.8% in the fourth quarter. But I guess, to kind of flip the narrative around here a little bit with the onetime insurance cost that you mentioned you absorbed in the fourth quarter, that makes the favorable 0.5% sequential decline in OpEx kind of actually a little more impressive. So I guess with the assumption that the insurance costs were probably up sequentially in 4Q versus 3Q. Just remind us which cost categories actually improved the most sequentially? And then also, were there any seasonal factors worth mentioning one way or the other that may impact that favorable sequential comparison on the OpEx?

Yes, Steve, this is Mark. Thanks for pointing that out. I should mention that earlier, but we've done a great job sequentially keeping our operating expenses actually declined a little bit. Contributing to that sequential change, utilities was a large contributor kind of quarter-over-quarter and actually a decrease in holding that relatively flat in same with general maintenance category there. Year-over-year, those two categories were up about $700,000 and $600,000. But quarter-over-quarter, we did a great job with our asset management team to keep those flat. And I think we're also seeing the results of some of our ESG efforts in the utility expense from LED upgrades, things like that, where we've made wise capital investments, and we're starting to see that reduction in the operating expenses from some of those projects that we completed this year.

Okay. Yes. And you mentioned that you don't normally do those sequential comparisons. But again, just -- I guess the reason why you don't do that? Is there just some seasonality factors that just mucks that up sometimes. Just curious on any reminders on any seasonal factors on sequential comparisons, either 4Q to 1Q or just any other times throughout the year as far as any obvious ones that stick out to you?

Yes. The obvious one would be snow removal in markets. North Dakota was hit pretty hard with our snow removal costs in the fourth quarter. But really, we don't have a lot of seasonality in our operating expenses outside those obvious ones. And again, our highly occupied triple net lease portfolio help insulate the overall NOI same-store numbers there. But clearly, we watch that carefully for our health care tenants and partners because it's the overall occupancy cost that matters when we talk to them about lease renewals.

Next question comes from Mike Mueller with JPMorgan.

So, two questions. First one, on the $200 million of development funding that's under discussion, I guess if all that comes to fruition, how much capital do you think could go out the door in 2023 and generate a return on it? That's the first question. Second one is, what's the return profile on piecing these smaller condos together like in Atlanta versus a typical building acquisition that you would make?

I can't help a laugh at the second question because it's a great question. Actually, the long-term return profile there is much better than about anything else we do. It's just taking time. It's a very strategic location. For some reason, 20 years ago, 25 years ago, physicians and hospitals that condo projects for the right way to build buildings and invest in buildings. And in this particular case, a condo was built in an incredibly strategic location across the street from 3 health systems. And so, we're really excited about the long term. maybe the best kind of IRR or cash yield will ever get from individual investments, it just takes time to accumulate the condos over time. So great question. We know it looks odd, but at the same time, on the back end, we're going to have fantastic returns from those investments.

On the development, that's a good question. It takes 18 months to build these buildings. So, the ones under construction, or about to begin construction, those will -- it just plays out over time on the 18-month construction cycle. So, of that $200 million I mean for your model average it out over 18 months, but it's something like that. So it's -- and frankly, that's the projects we know we will probably finance this year or contractually commit to financing this year. And we're working on others. So, I think there are opportunities for kind of outsized investment on the development side.

There are no further questions at this time. I would like to turn the floor back over to John Thomas for closing comments.

Yes. Maria, thank you, and thanks, everyone, for joining us on the call today. We're really excited about 2023. It's a different market and at a different time, but we think a 20-year bull run in seller's market has turned into an outsized opportunity for DOC, Physicians Realty Trust, this year, and we look forward to seeing you at some of the investor conferences coming up soon. Thank you.

This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation. Have a great day.