Published on : October 22, 2010

The Future of Medical Real Estate

The Future of Medical Real Estate

As we slowly emerge from what some have called the Great Recession, most forms of medical real estate have weathered the storm in relatively good shape. With the advent of healthcare insurance reform (that legislation fell far short of true healthcare reform), many pundits are predicting a solid future for the healthcare real estate development industry. A number of factors are at play that will impact its future growth.

Capital

Though medical real estate didn’t experience the same severe dissipation of capital that commercial real estate faced during the darkest days of the credit crisis in much of 2008 and early 2009, capital was a precious commodity at the time. Equity capital was available, but at a higher cost. Debt financing demanded more equity, higher pricing, guarantees, significant pre-leasing, and committed take-out financing, making it quite difficult to finance projects. Many institutional investors were on the sidelines. However, projects with good fundamentals were funded. DASCO closed on nearly $100 million of financing for healthcare development projects during that time.

From this experience, the industry has adapted to adjustments in risk tolerance. Gone are the days of 90 percent debt financing, sub-6.25 percent cap rates and lax underwriting by lenders. Significantly higher equity requirements, a strict focus on Class A properties, rigid due diligence procedures, and higher pricing have become the standard. It wasn’t uncommon in early 2009 to post 35-50 percent of a development project’s capital structure in equity. That level has subsided to a slightly more realistic 30-35 percent of the capital structure.

A number of secured debt lenders exited the market. No surprise. Many of the larger banks gorged on financial instruments we now know were toxic waste, subprime mortgages being the most publicized. In 2007 and well into 2008, banks were issuing funding commitments on development projects with 0-25 percent pre-leasing. When the credit markets turned south, most of those projects were canceled, foreclosed upon, or the related hospitals booted the developer and either shelved the project or turned it over to another developer. Those institutions that maintained sensible lending criteria and stuck to their knitting remained in the market and found a loyal group of developers/borrowers. Lender due diligence has become more rigid. Pre-leasing requirements of 65-75 percent on new development projects are now required.

As the flow of RFPs from hospitals picks up for outpatient facility development projects, hospitals are astutely demanding to know the capital resources available to developers. Recent entrants into the market will find themselves redlined and eliminated from further consideration, due to a lack of reliable capital, a depth of experience or both.

Supply/Demand Imbalance

Throughout the recession and the credit crisis, an imbalance between the supply of buildings and the capital seeking to acquire them has caused values to remain buoyant. Prior to the recession, capitalization rates were firmly trending downward, driven by higher prices and sustaining a seller’s market. Cap rates were in the mid- to low-6s with a few trades breaking the 6 percent barrier. Once the recession hit, the volume of transactions subsided as credit was difficult to obtain, driving down values and sending cap rates north of 8.5 percent. Meanwhile, most medical buildings continued to exhibit strong fundamentals during this period, unlike commercial office, industrial and retail properties which have suffered increasing vacancies, delinquent tenants, past due loan payments and lenders calling loans.

This imbalance is more pronounced today as institutional investors such as REITs are flush with cash seeking quality investments. Hospitals are the main source of supply as they consider monetization strategies to sell non-core real estate assets. Because a financial strategy of diversifying capital sources is gaining strength among the hospital community, the volume of monetization transactions and outsourcing new development projects to developers should increase. There is ample capital awaiting these opportunities.

Economic Stability

Many hospitals and health systems suspended projects during the recession. Why? Inaccessibility of capital, weaker operating performance due to declining patient revenue and increasing bad debt and charity care, uncertainty surrounded the economy and employment, and the political gamesmanship regarding healthcare reform. Even when capital was available, hospital CEOs and their staffs made strategic decisions to delay expansion efforts because of these market uncertainties. As the CEO of one of our clients said, “Strategy trumps capital every time.”

Overarching all of this, however, is the future pace of an economic recovery. As this publication goes to press, economists debate the threat of deflation, a double-dip recession, and the potential onset of inflation. We are in tenuous economic times, both domestically and internationally. Consumer confidence is low. Housing prices continue to search for a bottom. Commercial real estate loans are defaulting at an alarming pace. Corporations hoard cash awaiting the next economic shoe to drop, thereby delaying capital spending and hiring. Until the economy finds its footing, our country will face high unemployment rates, depressed capital spending levels and consumer cautiousness. Healthcare providers will continue to struggle over decisions to proceed with new facilities.

Construction Costs

One of the recession’s benefits has been the resulting decrease in construction labor and materials. Depending on the region of the country, developers have experienced a 10-20 percent reduction in construction costs over the past 12-18 months. For example, DASCO was the beneficiary of a “rebound” project; one in which another developer failed to perform and the hospital sought our expertise to move the project forward. After bidding the construction costs and comparing them to previous bids, every line item was lower except structural steel, resulting in a 16 percent reduction in the building’s budget. Though the hospital suffered lost time because of the failures experienced by the previous developer, the project can now proceed and offer more competitive rental rates to the physician community.

This phenomenon, though, may be short lived as the market is beginning to experience increases in some construction line items. However, with little competition from the commercial real estate market for new construction resources, stable construction prices may prevail a bit longer.

Sustainability

Sustainability has gained a lot of press, driven by the overhyped global warming phenomenon. However, reasonable and responsible energy conservation initiatives are valid pursuits and have increasingly found traction in healthcare facility development projects. LEED certification is increasingly finding its way into design, construction, and development RFPs for medical buildings. Improvements in design techniques and building materials are translating into future savings in building operations.

Though developers are always sensitive to the impact of higher costs, base LEED certification doesn’t necessarily add significantly to a project’s budget, yet can contribute to a building’s long-term efficiency. Thorough cost/benefit analyses and the ability to manage expectations and communicate realistic results will ring true among those tasked with delivering a sustainable project.

Experience

One of the major differences between experienced medical real estate developers and those who have drifted over from commercial real estate is the ability to effectively listen to, understand, and formulate sound solutions for a hospital’s outpatient and physician recruitment strategies. Skills at grasping, for example, a hospital’s oncology strategy and its various needs for healing space and radiological support, identifying the right physician tenants and understanding their particular growth plans, programming space efficiently to ensure proper patient and staff flow patterns, and creating the right design and construction team to deliver an aesthetically pleasing, cost effective, and design efficient facility are invaluable to the hospital and its goal of market share growth and profitability.

Successfully orchestrating all of these complex building disciplines delivers quantifiable successes on a number of fronts: more patient revenue to the hospital and physician tenants, more referrals from satisfied patients, more stable occupancy for the building, more real estate value created, and more meaningful relationships between the interested parties – developer/owner, manager, tenants, and hospital. The healthcare industry operates within a realm of trust. Experience honors that bond and knows how to deliver solutions to enhance it.

Compliance Risks

Though healthcare reform legislation has been enacted, its myriad rules and regulations are just now being written. The pace of their release will, over time, create more certainty in the healthcare industry. One aspect which may favor the healthcare real estate industry is this notion of self-reporting. Hospitals will be required to elevate the frequency of their reporting of compliance violations – activities such as illegal patient referrals, inadvertent inurement to physicians, below-market rental rates and above-market tenant improvement allowances.

There is great uncertainty among hospitals about the severity by which CMS and HHS might penalize hospitals for these infractions; those rules haven’t yet been written. Rather than risk unknown consequences, hospitals may increasingly monetize their non-core assets and outsource the development of outpatient and other ancillary facilities.

Physician Employment

A dramatic shift is occurring among physician practices nationwide. More physicians are selling their practices to hospitals. Declining reimbursements, increasing operating costs such as malpractice insurance, and the continuing assault from Congress on a physician’s ability to own and operate specialty hospitals are some of the reasons doctors are choosing to become hospital employees. Hospitals’ recruitment efforts include web tools such as Facebook and online hiring applications to attract physicians. Salaries, performance bonuses, 401k programs, generous vacation and medical benefits and other perks are drawing physicians at rates that are unprecedented and unheard of just ten years ago.

Another noteworthy phenomenon has gone relatively unnoticed. As new physicians graduate from medical schools, they are seeking a work shift and a lifestyle rather than a career. By devoting less time to the practice of medicine on a daily basis, some estimates indicate the industry will require 1.3 to 1.5 new physicians to replace one who is retiring. This country’s healthcare infrastructure is already lacking by nearly 35,000 physicians, 45,000 nurses, 15,000 pharmacists and 125,000 health aides and technicians to address the eventual integration of 32 million newly insured patients. The slight trend of increasing enrollments that medical schools have experienced over the last few years will not dent this severe shortfall, particularly when the lead time for training is considered. Anyone knowledgeable about the condition of the industry is predicting increased rationing of healthcare services.

Healthcare Reform

The passage of healthcare insurance reform legislation has permitted the industry a measure of temporary calm. However, thousands of pages of rules and regulations have yet to be written and published, which will certainly create innumerable unanticipated nuances and interpretations. Should the November mid-term elections evolve as many pundits predict, expect defunding threats, reform hearings and other changes as part of the ongoing political debate over this hotly contested topic.

So much has yet to be done to truly reform healthcare. For example, the equally important issues of affordability and quality were woefully absent in the legislation. The third leg of the stool addressed in the legislation – accessibility – will need to be reworked to include provisions conveniently avoided during the political debates: market based solutions that shift decisions away from government and back into the hands of patients and their physicians and bend the cost curve in the direction it was intended.

Healthcare reform will accelerate the shift away from the inpatient environment as it forces the industry to find more ways to cut costs and practice more preventive medicine. The outpatient setting will continue to benefit from these efforts and from advancements of medical technologies, pharmaceutical research and medical procedures. Outpatient facilities will always be less expensive to build than a hospital, serving as a solid solution in the quest to provide a lower cost environment for the delivery of healthcare.

Some estimates have shown that supporting 32 million newly insured patients will require as many as 64 million square feet of new medical buildings nationwide to satisfy the surge in demand for healthcare. This high water mark is just that: too high. There are a number of variables at work that suggest the number is much lower. What is not being argued, however, is that medical office buildings and outpatient facilities will have a greater role in the delivery of healthcare and will continue to be viewed as a growing, stable real estate property type for years to come.

About the Author

Gordon is the senior executive for business development at The DASCO Companies. He is responsible for creating strategic relationships with healthcare providers around the country, introducing them to the full scope and array of services that DASCO provides. Prior to joining DASCO, Gordon was a managing director of strategic relationships at GE Healthcare Financial Services, meeting with senior executives of some of the country’s top 250 healthcare providers to develop unique solutions to meet their financial, operational, and clinical needs.

Prior to serving in GE’s strategic relationship group, Gordon originated senior secured loans that focused on providing creative financing solutions for medical real estate. He served in a similar role at Heller Financial after developing a business plan to create a national medical office lending program. Gordon presently serves as co-chair of BOMA’s MOB special interest group and its annual healthcare facilities conference. Gordon has served as a spokesperson on topics covering healthcare real estate development, monetization and financing. He has presented at the Congress of American College of Healthcare Executives, the American Institute of Architects and the Healthcare Financial Management Association and has moderated numerous panel discussions at BOMA’s annual healthcare facilities conference, the inaugural RealShare Medical Office Building conference and the inaugural Becker’s Hospitals & Healthcare Systems Conference. Gordon has published commentary in the Financial Times, the BOMA International Buildings Magazine, Modern Healthcare Magazine, the BOMA Chicago Office & Commercial Real Estate Magazine, and American Medical Association News publications. Mr. Soderlund is a CPA and has undergraduate degrees in accounting and production management from Eastern Illinois University.