A mid the historic growth of office investment sales over the last few years, the medical office sector has shifted from a tertiary investment option to an annual $2.5 billion market. With all the capital that has poured into the office sector over the last five years, the competition for properties has influenced buyers to diversify by apportioning a significant amount of their capital to medical office properties.

The medical office market can be subdivided into three unique niches: on-campus, near-campus and off-campus. An on-campus medical office building is located within a six-block radius of a hospital or health care institution, while a near-campus property is located within a one-mile radius of a hospital or health care institution. An off-campus medical office building is located anywhere beyond the above limits.

Despite the sector's growing popularity, there are challenges brokers must face when negotiating transactions. It's important to understand the nuances between these three categories and the drivers that influence property valuations. While an on-campus property will inherently attract a wide array of potential buyers, brokers must produce a much more aggressive marketing plan for near-campus and off-campus properties to attract the niche buyer that will offer the best price and terms.

The on-campus advantage

Investors are willing to pay a 10% to 15% premium for on-campus medical office buildings — depending on the location of the hospital system, its credit rating and a variety of other factors — and accept lower returns. An on-campus office building offers patients the convenience of seeing doctors and specialists in one trip, while offering doctors the ability to confer with patients without leaving hospital grounds.

This widespread interest was reflected in a $30.3 million, five-building medical office building portfolio sale by Marcus & Millichap's Healthcare Real Estate Group. The excellent on-campus location and strong demographics led to substantial buyer interest and several offers within the first 10 days of marketing. The buyer purchased the portfolio at a 5.8% cap rate, the lowest ever reported by CoStar for a multi-tenant U.S. medical office building with a non-credit tenant.

The combination of Class-A location, excellent tenant mix and strong investor interest led to a cap rate of 100 to 150 basis points below the market average for on-campus properties. Properties located in strong demographic areas that combine a high percentage of senior citizens and young children will command even lower cap rates, depending on the lease structure in place.

Demographics make a difference

When marketing a near-campus building, a broker can face a more challenging marketing environment. While the property is still near the hospital, it is not as convenient as an on-campus medical building, and not as attractive to investors. Also, without the security of being located directly adjacent to the hospital or health care facility, the perceived stability of the tenants is slightly reduced.

Nonetheless, a property in a market with strong demographics and a solid tenant mix can still command substantial investor interest. Such was the case in a sale of three medical office buildings for $59.25 million in Rockville, Md., in a deal brokered by Marcus & Millichap. This Class-A, multi-tenanted medical portfolio, located a quarter mile from the Shady Grove Adventist Hospital, was 100% leased at the time of the sale. The tenants are a diverse mix of medical office users.

The high sale price on the property and its proximity to a medical campus narrowed the pool of potential buyers. After an aggressive marketing campaign, Washington Real Estate Investment Trust purchased the assets at list price, or $420 per sq. ft., and an average cap rate across the portfolio of 5.9%.

Off-campus disadvantages

Medical office properties located off-campus provide the greatest marketing challenge to brokers. Located away from hospitals and health care institutions, these properties do not carry a high level of convenience for doctors or patients and lack the stability and security of being within earshot of the hospital or health care institution. Typically, these properties have higher vacancy rates and command lower rents than buildings in the other segments, and therefore trade at higher cap rates.

Nevertheless, an aggressive marketing campaign and an ability to convey the positive aspects of the property can lead to a successful sale. Although they typically have higher vacancy rates, the off-campus properties provide a greater upside opportunity for investors and appeal to a different investor type than the other segments.

The three segments of the medical office market create different challenges for brokers, but targeted marketing can surmount these obstacles. While knowing your property and targeted investor pool can result in higher prices and lower cap rates, there is no substitution for superior location and excellent demographics.

Alan L. Pontius is the national director of Marcus & Millichap's healthcare real estate group. The firm is based in Encino, Calif.