Favorable demographics will continue driving demand for medical office space over the next decade, based on a new report from Marcus & Millichap’s healthcare real estate group.
With the 55-plus population expected to increase by 25% —15 million individuals — through 2017, the report projects that investors and developers will increasingly look to this office niche for growth and stability. Developers may have already noticed: Roughly 14.5 million sq. ft. of new medical office space is expected to come on line in 2007, up 9.5% from the 2006 volume.
“In the short term this might push vacancy up slightly,” says Alan Pontius, managing director of healthcare real estate at Marcus & Millichap. “But I don’t see supply risk as a tremendous problem for the medical office market,” adds Pontius, who calls medical office a good, long-term bet.
One reason is that the typical medical office property is leased long-term and has low tenant turnover. Pontius says that doctors tend to remain in the same space longer than most office tenants. He also says that a medical office property usually houses higher-credit, quality tenants. As a large chunk of the U.S. population ages past 55, demand for medical services will only continue to climb.
Pontius also expects increased tenant demand to push average asking rents for medical office space up 4% to $23.73 per sq. ft. by the end of 2007. The advent of better-quality supply also is impacting rental rates: Pontius says that much of the new, Class-A medical office space being developed comes to market with higher asking rents.
“Supply might not help landlords really push rents, but I still see average rents climbing this year,” he says.
Investor demand for medical office properties has kept capitalization rates (or initial yields) down around 7%, but Pontius expects cap rates to increase marginally over the next few years. The lion’s share of that increase will stem from the rising cost of capital rather than weaker demand for these assets, he says.
Much will also depend on where the medical office property is located. Austin and southern California’s Inland Empire will post the largest growth in residents 55 and older through 2011. Phoenix, Orlando and Charlotte — three cities popular with retirees — should also post 20%-plus increases in this demographic group.
That may explain why the southwest/mountain region saw a dramatic increase in new medical office construction in 2006. Developers completed 4.7 million sq. ft. of medical office space in this region last year, and roughly 32.8 million sq. ft. is expected to hit the market in 2007. Vacancy increased 60 basis points to 11.7% between midyear 2006 and 2007. But Pontius expects medical office market vacancy in this region to actually hit 11.3% by year-end as deliveries fall short of demand.
“Medical office was once viewed as a higher-risk specialty asset,” says Pontius. “But these properties have clearly become mainstream for both private and institutional investors.”