Investor bullishness over the medical office sector is growing as all signs point to a coming development wave. The first of the roughly 77.6 million baby boomers born between 1946 and 1964 began turning 65 this year — the magic Medicare age for most. More than 7,000 boomers will celebrate their 65th birthday each day in 2011, and 3 million to 4 million will turn 65 each year through 2030.

At the same time, the Patient Protection and Affordable Care Act is slated to add 32 million more Americans to the insurance rolls in 2014. While legal challenges could scale back or even dismantle the act, it is widely believed that the federal government has set a course to reform health care with an eye toward expanding access while trying to tame costs.

At a minimum, the new law has provided health care systems with enough clarity to begin planning for expansion. What's more, health care systems are adopting strategies to provide care in more outpatient settings. In some cases they're locating buildings off campus and closer to patients, much like an expanding retailer (see sidebar).

Meanwhile, the definition of medical office continues to evolve. Rather than just a box that holds physicians of various disciplines, the facilities now may include outpatient surgery or diagnostic imaging centers.

According to Modern Healthcare magazine's construction and design survey released in March, the industry broke ground on 526 outpatient facilities and medical office developments, renovations and expansions valued at $4.3 billion in 2010. But nearly twice as many future construction, renovation and expansion projects valued at $7.1 billion were in design in 2010.

“The demand for health care development is not going down,” says Danny Prosky, president of Santa Ana, Calif.-based Grubb & Ellis Health Care REIT II. The non-traded real estate investment trust has built a portfolio of 54 assets that are predominantly medical office buildings. “It's a little harder to finance projects, but demand is there.”

Forging game plans

Against that backdrop, it's no surprise that institutional investors are pouring equity into the medical office space. While they're chasing existing assets and driving up prices, they're also maneuvering to bankroll new developments, which typically generate cash-on-cash returns of 8% to 9%, experts say.

During the past several months, for example, developers and institutional investors have conducted a flurry of mergers and acquisitions.

While the transactions have certainly helped some diversify their portfolios, they also are ensuring that developers have war chests to fund property acquisitions and development, particularly as the debt market remains constrained.

Health care REIT Ventas completed its $7.6 billion purchase of Nationwide Health Properties on July 1. Nationwide's portfolio of 667 health care properties at the end of 2010 included 134 medical office buildings, 298 senior housing properties and 212 skilled nursing facilities.

As part of the transaction, the REIT inherited a strategic partnership with San Diego-based medical office developer Pacific Medical Buildings, which provides Ventas with a $1 billion acquisition pipeline in 11 western states.

The Nationwide deal comes on the heels of Ventas' acquisition of medical office developer Lillibridge Healthcare Services in 2010. The REIT has boosted its medical office property count to 230 today from 26 at the end of 2009.

Ventas derives 11% of its net operating income from medical offices, up from 5% at the end of 2009.

In addition to increased demand, health care reform will also push many medical services to lower-cost settings like medical offices, predicts Raymond Lewis, president of Ventas.

“We see a lot of excellent fundamental drivers in the medical office space. At the same time supply is relatively constrained,” he says. “It's a space that we want to continue to grow in.”

According to Marcus & Millichap Real Estate Investment Services, developers completed 4.7 million sq. ft. of new medical office space in 2010 nationally, a 52% drop from 2009. The medical office vacancy rate was 11.8% at the end of 2010, an improvement of 50 basis points from the prior year.

Although developers will add 7.9 million sq. ft. in 2011, medical office users will absorb 10 million sq. ft., according to Marcus & Millichap. The vacancy rate is projected to fall to 11.2% by the end of the year.

Meanwhile, Australian project management and construction behemoth Lend Lease in February acquired Dasco Cos., a medical office developer based in Palm Beach Gardens, Fla.

Now known as Lend Lease Dasco, the firm has developed and acquired health care projects valued at $1.6 billion, and it is developing some $205 million in new projects.

Lend Lease, which is listed on the Australian Stock Exchange, has cash and credit lines that exceed $2 billion, says Malcolm Sina, president of Lend Lease Dasco.

“The need and ready access to capital is causing more consolidation in the industry,” he adds. “There are many more projects that we can develop out of our own cash now than we could have as a privately held company.”

Institutional staying power

Medical office buildings have enjoyed a spike in popularity over the last several months. It's not the first time. Institutional investors historically have flocked to health care assets during recessions in a search of steady yields.

Upon an economic recovery, however, they've largely rotated out of the assets to capture more upside amid rent spikes in conventional office buildings and other properties, notes Shawn Janus, a managing director with the national health care group for Chicago-based Jones Lang LaSalle.

But Janus and other experts argue that institutional investors now are committed to the properties for the long term to balance their portfolios.

As evidence, they point to the downward ratcheting of returns on existing medical office properties, many of which are yielding 6% to 7%. Those levels of returns are generally associated with core real estate.

“A lot of people weren't familiar with this product and didn't have a comfort level with it when we started in the business more than 15 years ago,” says John Driscoll, president of Alter+Care, the health care development arm of Skokie, Ill.-based Alter Group. “Now this submarket of real estate has become more of a commodity than speculation.”

In particular, medical offices tend to provide steadier cash flow and tenancy compared with conventional office buildings, especially if a sound healthcare system anchors the property. Sina of Lend Lease Dasco says that 85% of medical office tenants renew their lease versus 60% in general office properties.

Awash in cash

Just as in other areas of real estate, investor demand for medical office assets exceeds supply, whether it's the acquisition of existing properties or financing new development.

“There has been a ton of capital formation to pursue health care assets,” says Jones Lang's Janus, whose group provides development, management and consulting services to health care providers. “The problem is that there has not been a ton of product on the market.”

Sales of medical office buildings in the first half of 2011 totaled $837 million, a decline of 21% from the same period in 2010, reports New York-based Real Capital Analytics. Sina attributed the lull to uncertainty fueled by the debt ceiling debate in Washington, D.C. He anticipates that transactions will accelerate in the second half of this year.

The average capitalization rate, or initial yield based on the purchase price of an asset and its annual net operating income, has steadily slid on a rolling 12-month basis.

Cap rates declined to an average of 7.9% through the second quarter of 2011 compared with nearly 8.5% during the same period in 2010. That indicates that sellers have enjoyed significant pricing power as demand for product has outstripped supply.

Medical offices under construction are largely developments that health care systems wanted to begin building two or three years ago, observers say.

The financial crisis in 2008 and the subsequent recession, which pummeled earnings in the health care industry, delayed the projects. Months of uncertainty amid the health care reform debate stymied action, too.

In the Denver suburb of Westminster, for example, NexCore Group in late June broke ground on a 48,000 sq. ft. medical office pavilion for St. Anthony North Hospital.

The $16 million development, which was put on hold for a few years, will anchor a new 35-acre campus for St. Anthony. In addition to doctor offices, the facility will include a 24-hour emergency room and an imaging center.

Still, the recession's silver lining may well be that it forced health care systems to think differently about capital and real estate, says Greg Venn, CEO of NexCore, which has developed, acquired and managed 5.2 million sq. ft. of medical office space.

“Systems that would have historically built and owned their own building are now thinking that maybe it's a good idea to have a third party developer do it,” notes Venn, whose firm is developing 470,000 sq. ft. of medical office projects. “They became keenly aware that there were other types of capital out there.”

Bricks or docs?

Developers and investors hope that sentiment spills over to existing assets, which could accelerate the pace at which health care systems sell and lease back their facilities to raise capital.

For several years, buyers have predicted that spending on new equipment and technology would lead the health care systems to “monetize” their properties. But the process has been moving at a very slow pace.

Institutional investors own 9% of health care real estate in the U.S., which is estimated to be a $1 trillion market, says Prosky of Grubb & Ellis.

While health care systems put the need to address real estate issues on their “Top 10” to-do lists each year, other important concerns frequently grab their attention, Janus adds.

But experts say that health care systems will ratchet up their monetization programs as reform takes hold.

“Hospitals are going to have to make a ‘guns-or-butter’ decision on whether they're going to invest in the patient-treatment infrastructure, or keep capital tied up in real estate,” says Lewis of Ventas. “Reform could be the tipping point.”

Joe Gose is a Kansas City-based writer.

MEDICAL OFFICE SALES STALL, BUT CAP RATES FALL

After rebounding sharply in the first half of 2010, sales of medical office buildings began to taper off. Even so, investor demand remains healthy as evidenced by the falling cap rates.

First Half of Year Sales Volume* Cap Rate**
2008 $2.5 billion 7.05%
2009 $689 million 7.66%
2010 $1.1 billion 8.45%
2011 $837 million 7.95%
* based on transactions $5 million or higher
** rolling 12-month average

Source: Real Capital Analytics