Medical office buildings offer investors higher return with less risk

For years, the medical office building market occupied a quiet, unexceptional corner of the commercial real estate market.

No one expected to make a fortune owning medical office buildings. Rather, investors turned to this market to make a steady return with lower risk. Medical office buildings tend to be occupied by long-term tenants that have much less turnover than traditional office space.

However, today the level of interest is booming. The medical office building market has become a vibrant and growing segment of the commercial real estate market, attracting attention from REITs, finance companies, and even foreign investors. In 2014, total transaction volume increased dramatically to almost $9 billion.

Consolidation and Competition

What's happened? Several trends have converged to ignite the market. The first is health care consolidation, which has been gathering momentum since the turn of the century, driven by the progressively rising cost of medical technology, government mandates in such areas as electronic medical records, and lower reimbursements.

In recent years, the pace of consolidation has been amplified by the passage of the Affordable Care Act (ACA) and the accompanying shift in funding from "fee for service" to "fee for outcomes." According to the New England Journal of Medicine, the ACA "has unleashed a merger frenzy, with hospitals scrambling to shore up their market positions, improve operational efficiency, and create organizations capable of managing population health." The journal cited 105 deals in 2012, compared to just 50 to 60 annually in the prerecession years of 2005-07. According to Moody's rating agency, they expect the trend will continue through 2015 due to the ACA and stresses on reimbursement.

But consolidation in itself does not account for the transformation this market has experienced. Health systems have also been restructuring, most commonly to create a three-tier system that enables them to maximize the patient population while delivering care at the most appropriate setting. This organization is built around a regional, capital-intensive tertiary and quaternary care center, which is in turn fed by smaller hospitals that address routine surgical issues. At the base of the pyramid, an expanding network of local clinics housed in medical office buildings supports the entire structure.

The importance of these local clinics is only intensified by the competition that is the inevitable consequence of consolidation. As systems expand, they have begun to encroach on each other's territory by establishing new clinics. As a result, there is a premium on desirable medical office space in these frontline areas.

Baby Boomers and ACA

The second trend behind the surge of activity in the medical office market is demand growth. By 2020, the population over 65 will rise from 46 million in 2014 to 56 million. U.S. Census estimates this number will reach 74 million in 2030. This group averages more than twice the number of office visits each year than the rest of the population.

The aging population, however, is not the only source of demand. Here, too, the ACA is making a substantial difference. According to the Department of Health and Human Services, 10 million people now have health insurance as a result of the ACA, either directly through marketplace plans or through expanded Medicaid coverage. The first stop for many of these newly insured is their local clinic or doctor's office housed in a medical office building.

It's Economics 101

The final trend that's influencing the medical office building market is also supporting the broader commercial real estate market: historically low interest rates that year after year, despite expectations to the contrary, have remained low. These low rates have tended to elevate prices for medical office buildings, so much so that many cash-strapped health systems are turning to their real estate holdings as an alternative source of funds to fuel their expansion and to equip state-of-the-art facilities. Increasingly, we are seeing very large sale-leaseback deals as hospitals tap their real estate holdings for capital investment.

On the other side, we're seeing investors — like REITs — with an abundance of cash on their books show interest in these properties. REITs now account for nearly half of the market volume for medical office buildings.

A Matter of Timing and Knowledge

Although their cap rates have contracted, medical office buildings still offer an attractive alternative for commercial real estate investors. Now, high quality medicals office buildings generally sell in the 5.5 to 6.5 cap rate range, depending on specific factors of an asset, they still compare favorably to many other forms of commercial real estate. Because they attract larger, more stable tenants for longer leases, investors gain a relatively higher rate of return with less risk.

To benefit from this equation, however, investors must know as much about the healthcare industry as they do about local market conditions. This blend of knowledge is particularly important for properties on the periphery of healthcare networks in the kind of smaller cities and suburbs that investors usually avoid. Investors can make up for their lack of local knowledge with an in-depth understanding of the financial position and prospects of the health system that acts as their major tenant.

Getting the Right Financing and the Right Relationship

A final reason that the medical office building market has done so well recently is the increase in lenders competing for investors' business. Banks, finance companies, and life insurance companies are all active in this area.

When weighing potential partners, borrowers should also give special consideration to lenders' capacity. Not every lender has the resources to handle the larger deals that have become increasingly common. Expertise is also a critical differentiator, as medical office buildings are a niche market that requires a firm grasp of the many trends that are shaping it. Finding a lender who can offer an informed perspective in addition to financing can make the difference between an ill-advised investment and one that captures all the advantages of this market, relatively high returns for relatively low risk.

Todd Gordon is a Managing Director with Capital One's healthcare team, focused on structuring, underwriting and closing healthcare asset-based and real estate financings. He has more than 16 years of finance experience, both as a lender and a lawyer.

Dan Berger is a Senior Director with Capital One's healthcare team focused on originating and underwriting asset-based and real estate transactions in the healthcare sector to a wide variety of healthcare operating companies, REITs, and public and private investors.


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