Carl Ohly was a young Atlanta accountant looking for a business to invest in back in 1972 when a friend told him about a medical office building project that had run aground in mid-construction. The building was far from completion, but it had commitments from physician tenants to occupy 70% of the space for 10 years.

The numbers snapped Ohly to attention. The project was past its break-even point and had no chance of failing unless a whole cadre of doctors somehow lost malpractice lawsuits all at once. Under Ohly's fresh stewardship, the building was completed and fully occupied in short order. Nearly 35 years later, the firm that Ohly co-founded, Meadows & Ohly LLC, has surpassed 5 million sq. ft. in medical office development valued at more than $600 million.

But the business has dramatically changed. Medical offices were once erected by sponsoring hospitals or amateurish partnerships of doctors together with airline pilots, lawyers and accountants, with construction often performed by homebuilders or small commercial outfits. Now the biggest pension funds and developers are eagerly investing in the category, drawn by stable returns buttressed by high occupancy rates, long leases and low tenant turnover.

“Beginning about 10 years ago, we began to see people in other commercial real estate markets getting interested in health care real estate. They didn't know much about medicine in most cases, but that didn't stop them,” says the 61-year-old Ohly, who is widely recognized as one of the true pioneers of medical office building development.

In the past three years, he notes, the parade of new investors graduated into a stampede. “What really impresses people who are new to this business is the fact that medical office buildings are practically immune to economic cycles,” says Ohly. “Whether the economy is good or bad, healthcare seems to keep expanding.”

Inside the numbers

In the first nine months of 2006, according to New York-based real estate research firm Real Capital Analytics, some $3.64 billion in medical offices, or 288 properties, changed hands in the U.S., up 43% from the same period a year earlier. The average price paid for medical offices surpassed $200 per sq. ft. for the first time in 2005, rising 12% to $212 per foot. Regular office buildings trade for an average of $170 per sq. ft., according to CB Richard Ellis Investors.

Capitalization rates, averaging 9.5% just four years ago, have plummeted to an average of 7%. That puts medical offices, which once traded at a half-percent premium in cap rates to conventional offices, at the same level as the rest of the office sector. In the overheated California market, there have been scattered reports of medical offices trading for over $600 per sq. ft.

Nobody was predicting these soaring prices a few years ago. But so much money is eager to get into medical office investing at the moment that it should come as no surprise. Chicago-based LaSalle Investment Management, an advisor to major pension funds, raised its first medical office fund in 2001, with $90 million in assets, and closed it out recently with big profits being returned to the original investors.

Now LaSalle is raising a substantially larger second fund, picking up two medical office buildings in suburban Phoenix and another in Spartanburg, S.C. “Pension funds have gained knowledge about this sector, and there is now a general acceptance among investors of medical offices as a viable and attractive subset of the general office sector,” says Steven Bolen, a LaSalle managing director in Baltimore who heads up the latest fund.

“The additional influx of capital into the medical office sector has caused a compression in cap rates the last few years,” Bolen says. “But the yields on medical offices still look attractive compared with conventional offices.”

Yields getting pinched

Over the years RREEF, a unit of Deutsche Bank and one of the biggest pension fund advisors with $27.5 billion in assets, has sunk money into practically all classes of real estate. Earlier this year the company discovered medical office and is now partnering with NexCore Group LP of Denver with plans to invest at least $500 million in both new construction and older assets.

While RREEF has already landed some deals, the company finds itself competing against equity flowing from such big names as Morgan Stanley, Prudential and General Electric. “All of these groups got into medical offices initially because they thought they'd earn a premium yield over regular offices. Now that premium has disappeared,” says Peter Kloepfer, a senior managing director of NexCore. “This sector once acted differently from other sectors of commercial real estate. But it's becoming more the same all the time.”

The typical medical office tenant stays in place for 11 to 14 years — a huge draw for big-money investors. “Medical offices now give you similar yield to conventional office, but the beta is one-third that of conventional office,” says Kloepfer. “The risk factors are very low.”

While most doctors earn lucrative incomes, investors entering the fray for the first time are surprised to learn that they are price-sensitive tenants. Developers of new assets, in particular, find themselves hamstrung by older buildings nearby.

“A doctor who has been paying $15 per sq. ft. in rent in an existing office building won't move if you present him or her with sticker shock,” says Kloepfer. “New construction is more expensive, but the most we might be able to get in an example like that is $18 a foot for new space.”

That keeps a lid on profit margins on the development side, Kloepfer admits. Other observers note that Medicare reimbursements in recent years have risen at roughly the rate of the consumer price index. Doctors will therefore tolerate modest 3% or 4% rent increases annually, but not the 10% and 15% spikes common in other real estate classes.

Banking on demographics

Nevertheless, the macroeconomics of this niche office sector are enticing. There are currently 37 million Americans over the age of 65. The over-65 total is forecast to reach 55 million by 2020 and grow to 75 million by 2030. The U.S. spent $1.9 trillion on health care in 2004, a total expected to more than double to $4 trillion by 2015, accounting for fully one-fifth of the nation's gross domestic product.

“Baby boomers are wealthier and much more activist in making consumer decisions,” says James Moloney, managing director of Cain Brothers LLC in San Francisco, a health care investment banking firm. He confirms that “institutional capital has embraced healthcare real estate in the last five to seven years. Everybody is expecting baby boomers to utilize health care more aggressively than their parents did.”

“Some [investors] are putting their money into new pharmaceuticals and others may be investing in new knee-replacement techniques,” adds Glen Ezard, a senior consultant with healthcare consultancy Segal Advisors in Los Angeles. “You can hit it big if the company you're backing gets a new drug approved. Medical offices aren't going to bring those really large returns, but they do represent a way to tap into the aging trend without a whole lot of risk.”

Andrew Uchida, an associate at CB Richard Ellis, believes that the market for medical office buildings is still in the early stages. “The first large wave of baby boomers to reach 65 is 10 years away. Investors have not missed the boat. [They] still have time to formulate and execute a portfolio strategy for investing in medical office buildings.”

Outsourcing feeds trend

Hospitals are eager to cooperate. There are close to 6,000 hospitals in the U.S., with at least 85% operating on a non-profit basis. Two decades ago most of them erected and managed their own facilities with in-house staff. That began changing through the 1990s.

First, the federal government began reducing Medicare reimbursements. Then laws were enacted that limited the ability of a doctor housed in a medical office building to refer patients for tests and treatment to any facility on the same campus. Such self-dealing was deemed anti-competitive.

Consequently, hospital systems are now content in most cases to outsource construction and building management. Besides, the latest nuclear-powered equipment in hospital labs has become so expensive that hospitals, already hobbled financially by declining Medicare income, are now focusing their capital resources on their core acute-care needs.

Virtually every other expense is viewed as expendable and that can potentially be outsourced. Between 1994 and 2004, the spending on inpatient hospital services grew a modest 4% per year. In contrast, spending on out-patient services rose 12% a year.

Increasingly, the private sector is encouraged by hospital systems to own and manage a whole range of outpatient facilities, from ambulatory surgery centers and diagnostic imaging facilities to urgent-care clinics, all in addition to mainstay office buildings.

The category keeps expanding to newer subcategories. Chicago-based Alter Group has been developing medical office buildings for some 10 years, but recently has been engaged on such specialty projects as a wound-care clinic at a Provena hospital in Joliet, Ill.

In 2006, Alter acquired IBIS Group Inc. in West Chicago, Ill., a specialist in developing health and wellness centers — typically health clubs with an added layer of rehabilitation services. This has become a big business, with facilities ranging from 30,000 sq. ft. to 125,000 sq. ft. and costing $20 million and more to build in some cases.

Donna F. Jarmusz, the founder of IBIS who today is a senior vice president with Alter, says that health clubs increasingly are being broadened to include doctors' offices, cardiac rehab rooms, diabetes clinics, retail pharmacies and even optical shops.

A similar trend is occurring among medical office buildings. The old plain-vanilla structure is giving way to medical malls with a cornucopia of services, Jarmusz notes. “Doctors want other revenue streams in their buildings,” she says. “They want X-ray facilities, and a cardiologist may want a catheter lab and a gastroenterologist may want an endoscopic lab. Medical office buildings, as a result, are getting more complex all the time.”

Frenzied M&A activity

Asset-hungry REITs are climbing all over each other to get invested in medical office buildings. Murray Wolf, a consultant who publishes the newsletter “Healthcare Real Estate Insights” in Minneapolis, counts 14 REITs with holdings in the medical sector, though the companies are consolidating. Health Care REIT Inc. of Toledo, Ohio, announced in September that it was acquiring rival Windrose Medical Properties Trust of Indianapolis for $877 million.

Early in December another REIT, Health Care Property Investors Inc. of Long Beach, Calif., paid $141 million to buy out General Electric Co.'s 50% interest in the two companies' joint ownership of a portfolio of 59 medical offices encompassing 4 million sq. ft. Health Care Property now owns 265 medical office buildings.

One REIT, Washington Real Estate Investment Trust in Rockville, Md., recently acquired a half-dozen medical office buildings spanning 336,000 sq. ft. Sara Grootwassink, Washington's CFO, says that she's aware that the firm is bidding against a larger pool of rivals for each asset that comes onto the market. “Medical offices aren't easy to buy right now. But if it's a strategic asset, we choose a price we're willing to pay and we pay it.”

By strategic, Grootwassink adds, she is referring to the desire by Washington and other REITs to cluster their holdings on certain hospital campuses. Washington, for example, owns six buildings surrounding the Nova Fairfax Hospital in Fairfax County, Va., and four buildings around the Shady Grove Adventist Hospital in Rockville, Md.

The sky-high prices have led some owners to cash out. “As prices have moved up, we've seen locally owned portfolios and individual assets coming on the market,” says Vince Cozzi, vice-president of acquisitions at Ventas Inc., a REIT based in Louisville, Ky. Medical office buildings currently account for only 2% of its portfolio, but Cozzi aims to boost that percentage. “We own a lot of seniors housing and nursing homes already,” he explains. “However, medical offices are where we see the best opportunities in the future.”

Thinking for the long term

Meadows & Ohly in Atlanta turbo charges its development work by offering physicians a chance to invest in their own buildings. In some instances, doctors will put up as much as 80% of the equity for an ownership stake. “Just because a doctor has a stake in a medical office building doesn't mean he or she is obligated to stay as a tenant. We look for situations where the developer, hospitals and physicians are all working together for the long term,” says Thomas Rhodes, a principal with Meadows & Ohly.

Last July, Meadows & Ohly paid $122 million for a portfolio of five medical office buildings in North Carolina, the firm's biggest acquisition. The principals have enough private equity money behind them now that they could undertake a $250 million transaction in the coming year. “There is a lot of capital being thrown around this sector right now,” Rhodes says, “but experience still matters a lot, too. That's our big advantage.”

Lee Murphy is a Chicago-based writer.

Medical office buildings have specialized needs

For even the most experienced construction companies, medical office buildings present some unique challenges. This niche office product requires intensive plumbing — sinks in almost every room in a building — and extra power to accommodate electricity-sucking medical equipment such as computed tomography (CT) and magnetic resonance imaging (MRI) machines.

The list of special needs is a lengthy one. Medical office buildings require 50% more parking than conventional office facilities. Also, a standard office building typically requires 40% fresh-air filtration, but a medical office facility needs 95%. Heat must be zoned everywhere to keep disrobed patients comfortable.

Michael Leopardo, a senior vice president with Leopardo Construction based in Hoffman Estates, Ill., and who heads up his family firm's health care group, is feeling the pressure. “Construction costs today are up 10% to 20% from where they were two years ago,” he says. “It's caused some developers to cancel projects, but at this point nobody expects prices to go back down. We're coping the best we can.”

Leopardo Construction started building medical office facilities in 1996 and has grown the business to $85 million a year in revenues. The company also builds traditional office and industrial structures.

Ironically, even as cost pressures mount, developers seem to be multiplying in numbers. Murray Wolf, a consultant in Minneapolis, counted 35 developers specializing in medical office buildings in the U.S. in a survey two year ago, led by such industry stalwarts as Hammes Co. in Brookfield, Wis. and Rendina Cos. in Palm Beach Gardens, Fla. Each company erected more than $600 million worth of medical office buildings in 2005.

But in his latest survey, Wolf found that the pool of developers had doubled to 70 as companies such as Trammell Crow and Centex have cultivated large medical office divisions. Developers who don't have expertise in this niche are buying the knowledge. Duke Realty Corp., for example, recently acquired Bremner Healthcare Real Estate. Both firms are headquartered in Indianapolis.

This new generation of developers raises an important issue for some hospitals. Nick Checota, president of Landmark Healthcare Facilities LLC in Milwaukee, has been developing medical office buildings since the mid-1990s. He is currently building a 90,000 sq. ft. facility in Erie, Pa. on the campus of the St. Vincent Health System, at a cost of $14 million.

The building, due to deliver March 1, is already 87% pre-leased, and with rents of $18 to $20 per sq. ft. on a triple-net basis it will generate healthy returns for Landmark. Other developers might be tempted to resell the asset, but not Landmark. The firm has never sold a medical office building that it built.

Hospitals covet stability and typically maintain some control over medical office facilities by making builders accept ground leases on campus property.

“I realize there is a lot of new investment money in this marketplace,” Checota observes. However, hospitals prefer to build long-term partnerships, the real estate executive emphasizes. “They want their doctors to be assured of reasonable rents for years to come. They don't like the idea of buildings being flipped.”
Lee Murphy