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In many parts of the country, the commercial real estate market is starting to look sick: tightening credit, slowing sales, and growing vacancies because of business failures.

But one niche market seems healthy: hospitals and medical office buildings. Even in recession, people still need healthcare. Add that to the country’s aging baby boomers, inadequate hospital infrastructure, and growing outpatient services—and the market has a hale future.

While the commercial real estate market is widely expected to contract due to recession, the medical buildings market is likely to expand. “It will be somewhat of a recession-proof asset,” said Lee Asher, a vice president specializing in medical properties for CB Richard Ellis. “Its demand enables it to withstand these economic downturns better than other types of investment property, which are more volatile.”

“In good times, people are still going to go to the doctor just like in bad times,” he said.

Medical building investors said the industry’s growth is caused by several trends converging. First, the nation’s elderly is the fastest-growing segment of the population. Some 37 million of the U.S. population is more than 65 years old, a number that is projected to double to 75 million by 2030. National healthcare spending was $2.3 trillion, or 16 percent of gross domestic product, or GDP, in 2007. That is expected to hit $4.2 trillion, or 20 percent of GDP in 2016, according to the National Coalition of Healthcare.

“Anywhere you get these migrations of senior citizens, the demand for medical office space will increase,” said Jonathan Winer, executive vice president at Seavest, a leading private-equity firm investing in medical buildings.

Nationwide, the market comprises some 131,000 medical office buildings, with more than half consisting of two to four tenants, according to Montecito Research & Analytics. In 2008 through October, sales of 204 buildings added up to about $3.3 billion—or an average of $1.1 million each—with a weighted average cap rate of seven percent, based on Montecito’s analysis.

A wheelchair outside of a medical facility
An aging population has increased demand for medical facilities
Medical buildings are in high demand in the sun-belt areas, where retirees tend to settle, such as Palm Springs, Phoenix, Atlanta and Miami. Medical buildings are also needed in cities with aging populations, such as Las Vegas and Philadelphia. But experts said the market is in fact nationwide. “The bulk of the country has had a need for healthcare real estate,” said Danny Prosky, executive vice president for medical acquisitions at Grubb & Ellis Realty Investors.

Changes in the hospital industry are creating opportunities for investors. One change is business models. In previous decades, hospitals often owned the buildings they occupied. But in recent years, as medical technology grows in sophistication and price, many hospitals are selling their real estate to reinvest in their core business. They are using the proceeds to buy new imaging or surgery equipment, or build new outpatient centers in suburbs where patients live.

“They’re making a lot more money reinvesting their real estate profits in their core business, as opposed to continuing to own the real estate,” said Grubb & Ellis’ Prosky.

These hospitals sometimes sell their buildings on a sale-leaseback basis, where they become the building’s anchor tenant. These are quality leases, typically ranging 15 to 20 years, said Prosky.

Another trend is smaller hospitals. Many hospitals built in the 1970s housed up to 800 patients. These buildings are now “functionally obsolete,” said Seavest’s Winer.

Instead, hospitals built in the last decade typically house 80 to 100 patients. Medical office buildings, which are less expensive to build, are located on or outside the hospital grounds. These medical buildings house specialists who treat outpatient conditions such as diabetes, arthritis or orthopedics. “Many of the activities that were previously housed in hospitals are being pushed out to office buildings, because it makes economic sense to do that,” said Winer.

Another trend is the growth of outpatient services in hospitals. Because of advanced technology, many surgical procedures no longer require long overnight stays at hospitals.  “More and more of our visits to the hospital are done on an outpatient basis,” said Grubb & Ellis’ Prosky. “You show up in the morning, have your arthroscopic knee surgery...and you’re home by dinner.”

A large medical building
Advances in out-patient care have increased tenancy medical office demand and tenancy
This has also boosted demand for medical office buildings offering outpatient services. Whereas hospital services used to be 80 percent in-patient and 20 percent out-patient, those percentages have now reversed, said Seavest’s Winer. “Medical office buildings, clinics and surgery centers are becoming more and more important as places to do business, as opposed to the hospital itself,” he said.

Medical buildings are showing better returns than other classes in the commercial real estate sector. In the past year, the overall transaction volume for medical office buildings has dipped by 10 percent year-on-year. But this is little, compared to other asset classes, which have dropped 70 percent in the same period, said Grubb & Ellis’ Prosky.

Medical office buildings also enjoy higher tenancy rates than other building types. Specialist doctors tend to sign long leases—five to ten years—with a low turnover rate of 10 percent, according to statistics cited by Seavest’s Winer. Whereas typical office building vacancy rates are 16 percent, vacancy rates for medical buildings tend to hover at 10 percent, said CB Richard Ellis’ Asher.

Rental growth rates for medical office buildings have also outpaced other commercial building types. From 2000 to 2007, rents for medical office buildings increased an average of 2.8 percent annually, compared to 1.3 percent for commercial buildings, said Winer.

Small investors can enter the medical property market by purchasing stock in healthcare REITs, which invest in a broader market including nursing homes and assisted living centers. Investors can also join real estate syndicates comprising pools of investors.

Larger investors can buy medical buildings. Opportunities for private investors typically range from $1 million to $20 million, said CB Richard Ellis’s Asher. Those looking to invest in medical buildings at a lower price point could look into a real estate investment trust, or REIT. The investment quality will depend on factors such as: financial strength of the hospital, a medical office building’s proximity to the hospital, proximity to patients, building condition, environmental health, tenant credit strength and length of leases. As with any investment, due diligence is required.

Montecito Medical, a private real estate investment group, has gone on a buying medical building spree, averaging $200 million per year for the last three years. Since exiting the multi-family buildings market in 2006, Montecito has acquired 14 acute care hospitals, specialty hospitals, medical office buildings and surgery centers. “There is a tremendous need for capital from these hospital systems,” said Chip Conk, president of Montecito.

For Montecito, these investments are yielding healthy returns on investment. Medical office buildings chock up internal rates of return, or IRR, of 12 percent to 15 percent, while hospitals return 16 percent to 23 percent, said Conk.

But investors also need to understand the healthcare industry. For example, if a hospital or medical building is heavily dependent on Medicare patients, insurance policy changes could adversely affect the business. “You need to be conscious of what’s going on in the healthcare world and whether it’s aligned,” said Seavest’s Winer.

More players are also expected to enter the market, raising competition. Montecito Research & Analytics estimates that some 10 million square feet of new medical property will enter the market in 2009. But demand for outpatient and inpatient care will also grow by nearly 10 percent in the next five years, resulting in a shortage of doctors by 2013.

But, as with most real estate investments, the most important factor is the seller’s motivation, said Asher. In this market, most medical buildings are not distress sales, but sellers want to capitalize their equity.