April 2008 VOL. 2

Healthy Choice:
Investors seek medical office properties

After several years of frenzied development, medical office construction is slowing. But, investor interest in this niche sector remains strong, both from an acquisition and development standpoint.

"There still is a lot of development going on, but there is caution in the air," says John Driscoll, president of Alter+Care, a Chicago-based medical office developer and owner. Although healthcare systems' growth plans have been affected by the residential slowdown, there is still plenty of demand for space in the sector and rents are continuing to increase.

Over the past decade, the medical office sector has provided strong returns as investors have discovered this niche investment class. High rents, long-term leases and strong tenant retention make medical office properties a popular investment with private investors, as well as real estate investment trusts like Healthcare Property Investors and institutional investors like GE Healthcare Financial Services.

"We think there are plenty of opportunities to invest in medical office - both through acquisition and development," says Jason Dodd, president & partner of The Cirrus Group. Over the past 11 years, the Dallas-based medical office investor has built a portfolio of 54 facilities with a value of $2 billion through development and acquisition. Currently, the firm completes 15 to 20 medical office projects annually, primarily in major markets.

Healthcare evolves
Increased demand for healthcare and the evolution in the way Americans receive healthcare is driving growth in the medical office property sector. Healthcare expenditures are expected to double to $4 trillion by 2015 as demand for doctor visits and other healthcare related treatment grows, according to the Centers for Medicaid and Medicare Services, a government health care agency.

Population growth, an increase in the number of older Americans and increased longevity are creating an increased need for healthcare. Today, Americans are undergoing many elective and preventative procedures related to age: colonoscopies, mammograms and knee replacements, not to mention facelifts and liposuction.

But, it's not just demographics that are changing the healthcare industry - hospitals are pushing the industry to evolve, as are consumer attitudes and technology. Because hospital systems need to control expenses, they're pushing many procedures out of the hospital to ambulatory care centers and outpatient care clinics rather than expanding.

The overriding reason: hospital expansion projects are extremely capital intensive, with a price tag of $1 million to $2 million per bed. Or, to put it another way, hospitals cost about $600 per square foot to build compared with $250 on average for medical office space.

While more than 90 percent of surgeries were performed in a hospital in 1981, today only 47 percent are. Roughly, 16 percent are conducted in physician offices, and 37 percent are performed in free-standing surgery centers, according to the American Association of Hospitals. Moreover, the number of ambulatory care centers has increased substantially over the past decade - today there are more than 5,200 in the U.S. compared to just 2,425 in 1996.

Development slows
Most new medical office development is occurring in suburban areas, far away from urban medical districts. Every day, more MDs are moving their offices closer to where their patients live. Physicians have taken on a strategy that retailers have used for decades - moving into the neighborhood to get closer to the customer.

This year, about 3 million square feet of medical office space is expected to be completed, less than half the amount that came online in 2007, according to a recent report by Marcus & Millichap Investment Services. The medical office space added in 2007 was the largest inventory increase in more than seven years.

The vacancy rate for medical office properties has edged steadily higher, increasing approximately 140 basis points over the past six quarters to reach 10.5 percent. The rise, however, has been driven by the delivery of new space, not a slowdown in demand, Marcus & Millichap says. In fact, gross leasing activity and net absorption in the fourth quarter of 2007 were the strongest in seven quarters. Roughly 5 million square feet of medical office space was absorbed in 2007.

Even with the increased vacancy, rental rates continue to grow. Medical tenants are increasingly interested in relocating into new space because medical office space becomes obsolete more quickly than other types of real estate, primarily because of the advances in technology. Newer, more modern facilities and strong demand contributed to a 3.5 percent rise in asking rents in 2007.

However, the looming threat of a recession is expected to hamper rent growth in 2008, and Marcus & Millichap projects rent growth of 1 percent to 2 percent in most markets.

Hot investment
Despite the increased vacancy and slower rent growth, investor demand for medical office space continues. Last year, transaction velocity for medical office assets increased approximately 2 percent from the rate recorded in 2006. Last year, more than $5 billion worth of medical office properties changed hands, according to Real Capital Analytics Inc., a New York City-based research firm.

In fact, the credit turmoil that slowed transaction volume in the rest of the commercial real estate industry actually pushed investors toward the medical office sector. Compared to traditional office buildings, medical office properties have lower lease turnover because lease terms are generally 60 percent longer and tenant renewal rates run in the 90 percent range. Physicians are reluctant to relocate because it can cause them to lose patients, and also because they typically bear a large portion of the tenant improvements costs for new space.

"Many investors perceive healthcare to be a bit more immune to the fluctuations in other commercial properties because of its continued growth and reliance on federal funding," Driscoll says.

The average price per square foot rose 9 percent in 2007 after double-digit gains over the past few years, while cap rates averaged in the high-6 percent to low-7 percent range, according to Marcus & Millichap. Cap rates are expected to increase slightly this year and will likely range from 7.25 percent to 7.5 percent.

Medical office properties that are located on hospital campuses typically generate a 10 to 15 percent premium over buildings that are not close to hospitals. "Physicians are willing to pay more rent for the convenience offered by these buildings," says Alan Pontius, national director of Marcus & Millichap's healthcare real estate group in Encino, Calif.

But, Pontius is quick to add that a medical office building does not have to be on campus to be successful. He points out that there are many communities - particularly those that are in small or rural markets - that cannot support a hospital but still need medical care. "There's a need for medical services in every place," he notes.

Shawn Janus, a member of Jones Lang LaSalle's healthcare practice in Chicago, says medical office properties stand out as long-term investments. "I think it's going to be a hot area for investors for many years to come," he says.