With Healthcare Reform and the Growing Baby Boomer Population, Medical Real Estate is in for Changes

With Healthcare Reform and the Growing Baby Boomer Population, Medical Real Estate is in for Changes

As our population ages, healthcare real estate has become an ever-more important part of the overall commercial real estate landscape. Medical office buildings have emerged from the recession as one of the more popular new core asset classes, and lenders are willing to finance these projects as business will, presumably, remain stable.

Western Real Estate Business magazine asked two healthcare real estate experts to weigh in on this asset class and its financing options. Mindy Berman is managing director, healthcare, Jones Lang LaSalle, and Steve Orchard is senior vice president with George Smith Partners.

Why is medical office an attractive asset class to lenders today?

Berman: Medical office proved itself to be a more stable asset class than other property types in the recent downturn. Medical office occupancy stayed at much higher levels since hospitals, doctors and practice groups have a high tendency to stay in place. Healthcare isn’t recession proof, but it demonstrated its recession resistance. Investors looking for stable, predictable income like the characteristics of healthcare real estate. Plus, a high percentage of occupancy is tied to highly rated, investment-grade hospitals.

What makes medical office occupancy so stable?

Berman: Think about how long the doctors you and your family go to have been in the same place! Factors that drive continuity in healthcare occupancy are the significant investment in infrastructure for medical office and clinical space, and the synergies gained from locating in dedicated medical office buildings and in medical clusters close to hospitals. Healthcare is local and demand for services is pretty continuous, no matter what community you’re in.

Is there an expected increase in medical office property in the market?

Berman: Yes. Demographics are the biggest single driver of demand for healthcare facilities. The population of this country keeps growing, especially in the Sunbelt states, and, as a population, we’re getting older overall. These are the basic ingredients driving the need for hospital beds and outpatient services. By some estimates, as many as 180,000 new hospital beds will need to be built in just six states in the next 20 years — this translates into a new 175-bed hospital every week, a fairly standard size for a new facility.

Healthcare is also going through rapid consolidation both between hospital systems and with physician group acquisitions. The expansion of insurance coverage under healthcare reform in 2014 is expected to add 32 million covered individuals, a boon to demand, as well as financial support for healthcare providers. These factors, along with the rapid advances in healthcare technology, are driving the need for new and more technologically advanced space.

What are the recent trends in investor outlook for medical properties?

Berman: There has been a huge amount of capital raised for healthcare in the past two years. Healthcare REITs, for example, have raised a disproportionate amount of debt and equity capital relative to other property sectors — a total of $20 billion in the past 18 months. Healthcare, along with multifamily and self-storage, outperformed every other REIT class in this time period. Medical office has come into its own as a mature property sector with many investors viewing healthcare as core as opposed to niche or value add in the past. Healthcare is primed for investors looking for stable income, as it feeds directly into what lenders are looking for in terms of income, occupancy and tenant strength.

What are the factors driving the current healthcare real estate market?

Berman: There is growing alignment between hospitals and physicians, which translates to more direct physician employment by highly rated systems and co-location at hospital facilities. Procedures are moving rapidly to outpatient facilities since it is a substantially lower cost setting than a hospital facility, a move being propelled by reimbursement pressure. Advances in technology are supporting this movement to lower acuity settings. Physician practices are growing in size, leading to larger suite sizes. Factors like these are transforming the character of healthcare real estate as it takes on a more institutional scale and character.

Does active participation in the healthcare real estate market require players who are seasoned in healthcare?

Berman: There are many new investors attracted to this asset class because of its stable qualities. New investors frequently align with established players in healthcare to gain knowledge. This is critical because the factors that drive success in a highly regulated sector like healthcare are quite different than other property types. Working with hospital and physician tenants is a whole different animal. Plus, the cost basis for healthcare real estate is greater than general office, so understanding the requirements for investment success is more critical. Healthcare reform and reimbursement pressures mean that investors need to be well informed about factors that will drive success with their building tenants in what will be a period of significant change ahead.

What are the biggest trends you’re seeing in healthcare financing?

Orchard: The most obvious trend in healthcare real estate financing is appetite. Capital providers love healthcare. Currently, it is a favored industry. There are 3.5 million Baby Boomers turning 55 everyday. Healthcare spending has grown 10 percent annually since the 1970s, now representing 18 percent of the GDP. Additionally, the U.S. will add 5.6 million healthcare-related jobs by 2020, an increase of about 34 percent. Consequently, capital providers want to invest in real estate assets with exposure to this industry.

Because of this demand, institutional equity funds are studying healthcare assets and pushing to expand their investment within the niche. Start-up equity groups are forming to help the money find investments, and banks are picking up experienced staff to expand their capabilities.

This demand is also raising values. A 20-year-old medical office building for which I recently obtained a loan was underwritten at a value of $1,100 per square foot. I also recently arranged the sale of an outpatient surgery facility at a price of $1,400 per square foot. These metrics are supported by unique lease and market characteristics, but cheap debt and very hungry investors were important drivers. The capital wanted to be deployed into high-quality real estate with predictable cash flow and clear growth characteristics. And where else can that be found today but healthcare?

How is this market different today than it was five years ago?

Orchard: Healthcare assets used to be on the margins of the real estate capital markets. Investors and lenders wanted the basic four food groups: multifamily, office, retail and industrial. Healthcare was seen as specialized, complex and dowdy. Who wants to build a kidney dialysis clinic when you could build a new urban condo project with lifestyle retail and a boutique theater? Healthcare was left to the specialty underwriters.

Today, the tables have turned. Healthcare’s specialized real estate characteristics are a barrier to entry. Complexity promises higher yield. Dowdy is interpreted as safe. Not to mention, that condo project is now fractured and the theater underneath it only hosts seasonal pop-up discount stores. Today, everyone wants in on healthcare.

What advice would you give to anyone needing to secure healthcare financing in today’s market?

Orchard: Mitigate operating risk. While it is true that debt and equity sources are increasingly willing to understand the inherent complexity of healthcare revenues, underwriters are still scared of it. Capital providers may accept the complexity in order to find higher yield, but they do not like it. Healthcare real estate developers and owners should work creatively to mitigate operating risks. Look toward joint ventures with strong operators. Get some credit on the lease. Avoid significant exposure to legislative changes. In short, take what steps you can to insulate lease payments from operating issues.

Remember that getting a deal done is ultimately dependent on people – give them an incentive to take a risk and make them feel safe. Supply your underwriter with the tools to respond to their credit committee. If rebutting a whimsical complaint by the chairman takes more than a minute, the deal is probably getting benched. Capital providers are willing to understand operational complexity, but the simpler and more remote you can make it, the better.

What is the current relationship between medical office buildings and hospitals? Are investors still interested in both product types?

Orchard: Medical office buildings are popular investments, for all the demographic and economic reasons we have discussed, while traditional hospitals suffer from tremendous complexity that cannot be easily insulated. Hospital bureaucracy and licensing issues are also hurdles. But hospitals and MOBs are not an apples-to-apples comparison.

Medical office buildings serve private capital well — they are understandable and scaled appropriately. In addition, out-patient services that favor MOBs are expanding rapidly. But the healthcare industry is consolidating in pursuit of cost efficiencies and strength against insurance companies and legislative changes. Because of these efforts, big campuses are not going away. The closer you can position your MOB to a medical campus, the better – and preferably on it.

From a typical transactional perspective, the best situation is a privately owned medical office facility that is adjacent to a major hospital campus with a credit tenant on the lease.

Have you seen many green/sustainable healthcare projects cross your desk recently?

Orchard: All the new construction projects I see include some nod toward environmental sustainability. Certainly green initiatives provide operating efficiencies, but the direct economic benefits are pretty marginal from what I see. So the primary driver is political (i.e. winning entitlements and appeasing institutional tenants). The important thing is that sustainable development is becoming the norm.

Source: Western Real Estate Business, Nellie Day

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