Real estate investors have discovered healthy returns in the decidedly ill health care industry. Under pressure to slash prices even while suffering from rapidly increasing costs, health care providers nonetheless are proving to be stable, long-term tenants who can generate annual yields of 7% to 9% for medical office landlords. Graying baby boomers and shifting regulations, which have generated more demand for outpatient facilities, have only fueled investment in these properties.

The allure of medical office buildings hinges largely on predictable occupancy patterns. Doctors typically sign eight-year leases and have renewal rates of 90%. That figure compares favorably with the conventional office market where tenants today typically sign three- to five-year leases and have 60% renewal rates, according to Cain Brothers, a New York investment bank focused on the health care industry.

Medical professionals tend to congregate and stay put because it's good for business. They can offer patients the convenience of one-stop shopping, and physicians within the building tend to refer clients to each other. Medical office tenants also typically spend more money on high-end finishes than other tenants and often install expensive equipment, making it costly to pick up and move.

That all adds up to steady long-term cash flow, rent stability and fewer tenant improvement costs through the life of the properties. In fact, medical office buildings are emerging as the new “recession proof” property category, a distinction once held by grocery-anchored shopping centers. (For more on why grocery centers are now vulnerable, see “Appetite for Risk,” NREI, November 2005.)

Over the last two years, the average capitalization rates (the initial yield for investors based on the purchase price) for medical office buildings have dropped 250 basis points to 7.3%, according to research and consulting firm Real Capital Analytics. That's a measure of the intense demand for the properties.

“We're seeing a fundamental acceptance of medical office buildings as an asset class,” says Greg Venn, CEO of Denver-based NexCore Group, a private developer, owner and operator of medical office buildings with a portfolio of some 1.1 million sq. ft. valued at approximately $300 million. “Institutional investors finally did their homework and understand that it costs physicians a lot more to relocate — referral patterns are much more important than moving and maybe saving $2 per sq. ft.”

Chicago-based LaSalle Investment Management was one of the first institutions to target medical office buildings when it launched its $100 million medical office fund in 2001, and in 2005 Chicago-based Heitman invested some $250 million in this property sector.

Buying into the buzz

A sign that major investors have identified medical office buildings is the surge in transaction volume in these products. Sales more than tripled between 2002 and 2004, jumping from $857 million to $2.6 billion, according to Real Capital Analytics (RCA), which tracks deals $5 million and higher. Deals through mid-December 2005 reached $2.1 billion, says RCA, and the prices hit $182 per sq. ft., a 28% jump from $142 per sq. ft. in 2002.

According to estimates by the National Council of Real Estate Investment Fiduciaries (NCREIF), a Chicago-based association that tracks investment data from institutional members, tax-exempt funds hold some $508 million in medical office assets, compared with $104 million in mid-2004. Additionally, surveys such as Ernst & Young's 2005 Real Estate Private Equity Outlook suggest the enormous amount of capital pursuing conventional real estate is pushing money managers to consider alternative property types, such as medical office buildings and self-storage facilities.

Next obvious question: Are the new investors driving up prices and paying too much for second-rate assets? Jean-Claude Saada, chairman and CEO of Dallas-based Cambridge Holdings, a firm that's been developing health care projects for 20 years, says yes.

By his reckoning, many of the buildings trading hands lately are obsolete. They're aging and were not designed to accommodate the needs of high-tech medical groups. Also, medical groups tend to be larger, so spaces that were created for solo and small-group practices are not so easily filled.

DEMAND RISES FOR MEDICAL OFFICE BUILDINGS
(Deals $5 million and higher)
Sales Volume No. of Transactions Average Price Per Sq. Ft. Average Cap Rate
2002 $857 million 70 $142 9.7%
2003 $1.49 billion 77 $121 9.1%
2004 $2.62 billion 176 $172 8.3%
2005* $2.1 billion 159 $182 7.3%
* Through Nov. 15, 2005
Source: Real Capital Analytics


Despite all this, according to RCA, medical office buildings that are more than 15 years old have been selling at average cap rates of 7.3%, just 10 basis points higher than cap rates for buildings five years old or younger. “Unfortunately we're seeing a lot of crazy money overpaying for all the wrong stuff,” says Saada. “There's a lot of cash in the market, and not enough good solid projects.”

At the same time, new development is ramping up. Cambridge, for example, recently completed three projects around Dallas, which are valued at $105 million and include some 375,000 sq. ft. of leasable space. The company also is developing a $90 million, 175,000 sq. ft. medical office complex and 729-car garage in San Diego.

Nationwide, approximately $1.3 billion worth of medical offices were built in 2004, compared with $900 million in 2003, according to a survey cited by Cain Brothers. Additionally, some $6 billion of new medical offices are expected to be built over the next five years.

One factor driving the building boom is the creation of more outpatient facilities. In the hunt for new income streams, for example, hospitals are forming joint ventures with physicians to operate surgery centers and other outpatient services on campus or at satellite locations. Patients have spent nearly twice as much for outpatient care than they have for hospital care over the last decade, according to the Center for Studying Health System Change, a policy research organization in Washington, D.C.

Regulatory shifts have actually primed the outpatient facility boom. To cut costs, the Centers for Medicare and Medicaid Services, the federal agency that pays health care providers, has pressured doctors to perform lower-risk procedures outside hospital settings.

Many knee repairs, for example, used to require overnight stays in a hospital. Now they're done in outpatient facilities. “There are regulatory drivers that force these kinds of changes,” Venn says. “And we're going to continue to see growth in outpatient services.”

Service-minded developers

The potential growth of the health care facility industry is attracting developers from other property types. NexCore, in fact, is one of a growing number of developers taking a one-stop-shop approach to developing health care assets. Generally, NexCore, Cambridge and companies such as Chicago-based Lillibridge Health Trust and Houston-based PM Realty Group work with health care systems or physician groups to plan, design, develop, lease and manage medical office buildings.

PM Realty, a full-service real estate firm and longtime developer of office, industrial and apartment projects, launched its health care initiative nearly three years ago. Among other projects, the firm is renovating a 150,000 sq. ft. medical office building it recently acquired with Dallas-based Quorum Equities Group. The $6.5 million rehab will include the addition of a 15,000 sq. ft. surgery center.

NexCore's principals previously served as the development arm of Denver-based design-build firm Neenan Co., which specializes in health care, educational and conventional office projects. NexCore's executive team has 15 years of experience working on health care and other real estate projects. After an amicable split with Neenan to form NexCore in late 2003, the company's principals put more emphasis on the medical office sector and have increased their annual volume of medical projects to about $70 million from $30 million.

NexCore currently has 200,000 sq. ft. of health care facilities in various stages of development in several states, and Venn plans to increase the portfolio through acquisitions, especially as institutional investors pump money into the sector. “We don't see a lot of institutions just coming in and buying on their own,” Venn says. “They want to team with an operator that understands all the dynamics.”

Capital drivers

The good news for NexCore and similar companies: The market is ripe for investment. Hospitals own billions of dollars of facilities, and cash-strapped health care CFOs are becoming increasingly aware that they can capitalize the assets and plow the proceeds into new technology, services and equipment, says John Winer, a managing director with Ernst & Young's transaction real estate division in New York, who advises health care systems.

That wasn't always the case. “Years ago, it was challenging to raise capital for these properties,” Winer says. “But now they're understood by the investment community and are considered to be highly desirable.”

LaSalle Investment Management had to thoroughly educate investors about the product when it launched its medical office fund a few years ago, says Steve Bolen, president of the fund. “Medical office buildings weren't on investors' radar screens,” he says. “Now I think the properties are being acknowledged as simply a subset of conventional office buildings.”

Downside potential

There are some drawbacks to investing in medical properties. Health care system bureaucracies or government-approval processes sometimes slow projects. And leasing can drag on longer than in conventional office space, because developers must find a larger number of tenants to fill small spaces, typically 1,500 sq. ft. to 2,000 sq. ft., says John Wadsworth, vice president of Colliers Seeley International in Irvine, Calif. Plus, potential tenants are tough to contact because they spend their days seeing patients, adds Wadsworth, who is leasing or selling some 500,000 sq. ft. of medical space in Orange County.

Medical office buildings also cost upwards of 20% more to build than conventional office buildings, according to Michael Leopardo, vice president for the health care group at Leopardo Construction in Hoffman Estates, Ill. Typically there are sinks in every patient room and toilets in every doctor's office, driving up the cost of plumbing and creating buildings that re-quire more maintenance, notes Glen Perkins, executive vice president and managing director of Houston-based PM Realty Group, which began developing and acquiring medical office buildings within the last three years.

At the same time, he adds, doctors have become extremely sensitive to costs, since medical reimbursements have fallen and other costs have risen. “You've really got to be in tune to taking care of physician tenants,” Perkins says. “They're much more demanding than typical office tenants in most environments.”

Wide-ranging Medicare and Medicaid Stark laws, in conjunction with insurance rules, also add layers of complexity that can affect how buildings operate, says NexCore's Venn. If a hospital is leasing space in a medical building, for example, offering different incentives to different physician groups may violate Stark laws, which generally aim to prevent fraud and abuse related to Medicare and Medicaid payments.

Thus, the regulations, combined with more long-term tenants, ultimately may restrict medical building owners from jacking up rents in response to a tight market, a problem conventional office landlords generally don't have.

Overall, however, assigning medical offices to commercial portfolios is still regarded as a reduction in risk. Indeed, returns on medical offices are happily uncorrelated with the larger office market. A Cain Brothers study of San Francisco following the dot-com bust found that net effective rents grew to $34 per sq. ft. from $28 per sq. ft. between 1999 and 2004, while net effective rents for conventional office space fell to $25 per sq. ft. from $50 per sq. ft.

Cash flows also took divergent routes over that same period: Medical office buildings enjoyed growth of 22%, while conventional offices plummeted nearly 80%.

Additionally, areas with pent-up demand for medical offices have experienced solid rent growth. Case in point: In the Dallas suburb of Rockwall, PM Realty needed to achieve gross rents excluding electricity of some $24 per sq. ft. to justify development of a 90,000 sq. ft. medical office building, which is about double the average market rate, according to Perkins.

That compares with rents of $21.08 per sq. ft. for conventional Class-A office space in suburban Dallas, where vacancy rates are 23.4%, according to Grubb & Ellis. Nonetheless, the $15 million project, slated for a March opening, is 90% leased.

Orange County, Calif., is another market where medical space is at a premium. Developers there are selling suites within new medical office buildings as condominiums rather than leasing the offices, Wadsworth says.

Depending on their location, those condo projects are fetching anywhere from $424 to $550 per sq. ft., and often developers start constructing these medical office projects without tenants or buyers. “If physicians have their choice, they'd rather own than rent,” he says. “So, there are very few for-lease projects available.”

Value explosion

Investors hope to see continued appreciation in the facilities, and evidence thus far indicates the properties are paying ample dividends, even in the relatively short time that investors have started clamoring for medical offices.

In September, the LaSalle medical office fund sold the 2021 K St. in Washington, D.C. to New York-based Rockrose Development Corp. for $70 million, which represented a $27 million profit, or 63% more than LaSalle paid for the 155,000 sq. ft. building in late 2002.

On the other hand, higher prices eventually will put a clamp on yields, suggests LaSalle's Bolen. Originally, Bolen aimed for leveraged internal rates of return in the mid-teens over a 10-year period. While the fund was able to achieve those rates in just a few years because of growing demand for the properties, Bolen now anticipates those returns dropping a couple of percentage points as competition for medical office assets heats up. “We've seen cap rates compress over the last couple of years, just like in every other property sector,” he says.

LaSalle was one of the first institutions to target health care facilities. Among other investments, it partnered with Cambridge Holdings in 2002 to develop medical office buildings totaling 192,000 sq. ft. on the campuses of Presbyterian Hospital in Dallas and Sharp Memorial Hospital in San Diego. Recently, Cambridge recapitalized LaSalle's position using funds from a $400 million line of credit provided by GE Commercial Finance Healthcare Financial Services after LaSalle decided to liquidate the fund.

In conjunction with liquidating the fund — LaSalle's remaining four properties valued at about $75 million will likely sell in the first quarter of 2006 — the investment firm is launching another medical office fund for qualified investors. It is expected to close with about $300 million in the coming weeks.

Early in 2005, meanwhile, Chicago-based Heitman closed on a $400 million commingled fund that committed $250 million to Chicago-based Lillibridge Health Trust to finance on-campus medical offices. That helped fund Lillibridge's acquisition of 10 medical office buildings totaling 455,000 sq. ft. from SSM Health Care in St. Louis for an undisclosed price.

Consolidation, the next evolution

Like most commercial real estate, however, the medical office building sector remains highly fragmented despite the growing interest of institutional investors. Regional and local players dominate the space, particularly when it comes to health care facilities located off hospital campuses.

In fact, doctors often band together to own buildings, which creates an additional revenue stream — and often retirement savings — for physicians. Over the last 18 months, for example, the Beach Business Bank in Manhattan, Beach, Calif., which specializes in financing real estate for doctors, has provided $40 million in construction and permanent loans for physicians, according to Robert Franko, the bank's CEO. He expects to complete the same volume of business over the next 12 months.

But NexCore's Venn predicts a coming consolidation, particularly as shifting regulatory and market forces put a premium on developers who understand the industry's nuances. Consequently, he says, funds will expand the amount of capital available to the developers that emerge in those roles.

At the same time, Venn has no illusions that medical office buildings will ultimately divert investment away from more conventional real estate assets. “Will medical office buildings ever have the same level of allocation as retail, apartments or offices?” he asks. “Probably not. But there's a lot more room for investment.”

Joe Gose is a Kansas City-based writer.