Proceed With Caution: What Constitutes a 'Good' Deal in This Market

In this difficult economy, deal-hungry healthcare real estate developers and investors might
be tempted to consider just about any opportunity that comes down the pike. But that makes it all the more important for them to remain objective and disciplined, and to temper their yearning to do deals with a dispassionate analysis of the specific opportunities at hand.

That was one of the recommendations of a wide-ranging panel discussion during the recent InterFace Medical Office conference in Chicago.

In a session titled “The InterFace Big Picture: The State of the Healthcare Real Estate and Medical Office Market,” a healthcare developer, broker, investor and provider shared
their perspectives on the sector.

Special Report:
As publisher and founding editor of Healthcare Real Estate Insights™, I was invited to moderate the panel.
The panelists included:
 Todd Varney, Executive VP, Rendina Cos.;
 Chris Bodnar, VP Investment Properties, Private Client Group, CB Richard Ellis;
 Vincent M. “Vince” Cozzi, Managing Director, Acquisitions, Ventas Inc.; and
 Gina Weldy, Director of Finance & Real Estate, Northwestern Memorial Hospital

The conference was held April 28, attracting an audience of nearly 170 healthcare real estate professionals and hospital and health system executives to the Standard Club in downtown Chicago.

‘Some loosening’
Noting that the volume of requests for proposals (RFPs) for healthcare real estate development projects remains relatively strong, the first question for the panel was whether it is taking longer to get developments started, and whether some hospitals and health systems are scaling down or postponing projects.

“That’s something that we’re hearing anecdotally across the country,” Mr. Cozzi replied. Like managers in virtually every other business, he said, healthcare executives are being very careful and conservative with their decision making during this recession.

“Folks are making decisions in today’s environment that are different than the decisions that they’ve made in the environment where capital was … flowing much more freely,” he said.

As a result, some healthcare real estate projects have indeed been postponed or cancelled. The projects going forward tend to be those necessitated by patient care requirements and provider business strategies, he added.

“So we’ve seen, in some cases, projects that have just been put on the shelf. But we’ve also seen some loosening in terms of hospital support for projects that are critical to go forward,” Mr. Cozzi said.

He cited the example of an orthopedic/sports medicine project that Ventas had been trying to get off the ground for about a year and a half. That development would have proceeded
in years past with about 50 percent pre-leasing, he said. But, after the financial crisis, potential construction lenders and equity investors became more risk-averse and required greater levels of pre-leasing – up to 80 percent – which kept the project on hold. However, he said, the development finally moved forward during the preceding three weeks because the hospital stepped up with a significant lease commitment.

“So we’re definitely seeing projects move ahead, but they’re coming with more support from the hospital if it’s something that’s critical to the hospital’s strategic plan,” Mr. Cozzi
said.

Like lenders and investors, developers are also being more cautious, according to Mr. Varney. 

“You definitely have to be a lot more selective, particularly with new clients,” he said.

“We have passed on a couple opportunities where, probably three or four years ago, we would have moved forward with new clients,” he confided.

Mr. Varney said that Rendina Cos. carefully evaluates those opportunities, analyzing the hospital’s recent financial results and business strategy, the competition and the market. Another key factor is the hospital’s strategy for aligning with primary care physicians.

“And you have to make some tough decisions,” he said. “Unfortunately, there are some deals I get from time to time we’ll have to take a pass on. Hopefully those are few and far
between.

“But, when it comes to existing clients, we absolutely just find a way to get the deal done, whether we feel a little bit of pain in the short term for the long-term relationship,” Mr.
Varney said.

That can include bringing in joint venture partners, having the developer contribute more capital or requiring tenants to back up leases with personal guarantees.

“We’re doing 20 to 40 percent cash, depending on the deal,” he said.

Mr. Cozzi of Ventas said that a requirement of at least 40 percent equity has become typical.

Mr. Bodnar of CB Richard Ellis said some deals can still be done at 35 percent equity, but the same deals could have been done for 20 percent equity a year or two ago.

“There are definitely more opportunities out there,” Mr. Cozzi said. “Our CEO was having a
conversation which she relayed to me a couple days ago with one of the largest MOB developers in the country. That developer said to her… ‘Our pipeline’s full. We’re seeing a lot of great opportunities.’ She said, ‘How do you know?’

“And I think it’s a really fair question because there’s a difference between a lot and quality.” Just because deals are relatively more profitable than they were a few months ago, that still doesn’t mean they are “good” longterm deals, he continued.

“And how do you determine what’s ‘good’ in a world where you’ve got lots of alternatives for investment, whether it’s acquisitions or, in our case, investing in other asset classes?” Mr. Cozzi asked.

He said he agreed with Mr. Varney that each opportunity needs to be thoroughly analyzed. For equity investors, that means looking carefully at the risk-reward ratio.

“And, from a lending standpoint … there are just fewer people lending on medical office buildings because there are fewer people lending on real estate of all types,” Mr. Cozzi said,
although he added: “It’s a little bit of a safe haven. As I talk to lenders, they will look at medical office buildings as opposed to other asset classes, which they just won’t look at at all.”

Mr. Varney also said he believes that the need for developers to put more of their own capital into healthcare real estate projects might reducecompetition because only the well-capitalized developers will be able to get deals done. “I think there are going to be some
of them that have been in the marketplace that won’t survive,” hesaid.

Who is lending?
Asked who is lending, Mr. Bodnar noted that life insurance companies have dollars allocated for 2009, but most of those funds will go toward refinancings. “But there are regional banks out there that are still doing lending, which is great,” he added, although their terms are much tougher than they were a year or two ago.

“So there is debt out there,” Mr. Bodnar said. “Not a lot of people are saying it, but we have seen some improvement in the debt markets. But your sponsor has to be good, the real
estate has to be good and the tenant has to be good.”

“There are a couple of things that are clear,” Mr. Cozzi said. “The CMBS market is just dead and it’s not coming back – certainly not coming back anytime soon. So … on the permanent financing side, the life companies and the pension funds are really the only game. And that market is extremely choppy.”

Life companies that haven’t financed healthcare real estate in the past are reluctant to test the waters under current economic conditions, he said, and some that have financed this sector in the past “are just absolutely shut down this year.”

Officials at life companies also want bigger deals because such deals are more efficient, Mr. Cozzi said.

“That doesn’t line up well unless you’re working on a really large portfolio of medical office buildings, and there are not a lot of those large portfolios being traded right now, he said. “So working on smaller deals is tough.”

That desire for efficiency also affects the life companies’ choice of geographic markets, Mr. Cozzi said. “There’s really – as there always is during times like this – a flight to quality,” he said. “Lenders want to lend in major gateway cities on really
core assets.

“So if you bring them deals in secondor third-tier markets where they’ve got to change a plane in order to get there, or if it’s a lower-quality building or lower-quality health system, they just won’t even look at the books.”

As for banks, he said very few are even considering lending for medical office deals right now. And the few banks that are in the market will only consider loans for established clients
on deals for strong providers.

Although the tax-exempt bond markets are weak and debt is relatively expensive (in the 8 percent to 9 percent range), Mr. Bodnar said hospitals and health systems still have
access to capital.

In particular, he said more providers seem to be taking advantage of the U.S. Federal Housing Administration (FHA) Section 242 program. The Section 242 program has gotten a
bad rap over the years because the underwriting process was very slow, he said.

“It took forever to go through that program. It could take nine months to even go through the application process,” he said. However, the process has been streamlined in recent
years.

Perhaps even more importantly, the federally insured loan program offers lower interest rates (about 6.5 percent) and a greater loan-to-value ratio (up to 90 percent).

“Those are great terms you can get in today’s market,” Mr. Bodnar said. “You can use those funds for new construction, rehab projects and refis as well. So there are alternative
financing sources out there for hospital systems.”

Darlings and distress
Mr. Varney said that equity investors and lenders generally have a more favorable view regarding healthcare real estate right now than most other commercial real estate sectors.

“There’s definitely a difference,” he said. “Fortunately, we’re in a sector that, if there’s going to be a darling, I think healthcare is going to be the darling, although there are certainly
challenges.”

Historically, investors and lenders have been attracted to medical real
estate because the spaces tend to be leased by stable, creditworthy, longterm
tenants – primarily physicians. At a time when other sectors are struggling, that is even more attractive, Mr. Varney said.

“When you compare healthcare to retail, traditional office and other product … certainly, if there’s going to be money chasing the deals, then this is the sector to be in,” he said. “With
that said, there are certainly challenges that we have all spoken about today.”

Asked whether those challenges included defaults and distressed properties, the panelists said that remains rare in their experience. “We’re not seeing as much on the healthcare sector,” Mr. Bodnar said. Any MOBs that are running into trouble are probably either
functionally obsolete or should never have been developed in the first place, he said.

“Either they’re not located close enough to the hospital campus, they don’t have that relationship with the hospital (or) they built it too big without a surgery center,” he said.
“So there’s some component that’s missing.”

“You may see a little bit of distress on some really low-quality assets,” Mr. Cozzi added. But he said that even though many of the life insurance and banking executives he knows are
spending “a tremendous amount of time doing workouts, there’s little or none of that on the healthcare side.”

There have been rumblings recently that some landlords of mainstream office buildings with high vacancies are exploring plans to convert those assets to medical office. Ms. Weldy of
Northwestern Memorial Hospital was asked whether that is viable.

“It’s viable,” she replied. “We’re currently living through it in one of our office buildings. But I don’t think you can kid yourself; it’s painful.” She noted that the requirements for HVAC systems, plumbing, elevators and other building systems are very different for MOBs. Property management, housekeeping and security expectations will also change if an
ordinary office building is converted to an MOB, she said.

“So I think it’s viable, but it’s not something that you can just do overnight, and start finding medical tenants. I think you really have to think about the use of the entire building before you start making those changes,” Ms. Weldy said.

Mr. Varney of Rendina Cos. said that the idea of office-to-MOB conversions does seem to be coming up more often lately – sometimes driven by the hospitals themselves.

“Certainly in a congested market – downtown markets – you may not have the option to do new (construction), so sometimes you have to take advantage of what you have,” he said. “But it certainly is challenging.”

Ready to (third) party?
Given that tax-exempt bonds and other sources of capital are more limited and difficult to obtain, Ms. Weldy was asked whether hospitals and health systems are becoming more receptive to third-party development and ownership.

Implementing its 10-year plan has long been Northwestern Memorial’s top priority, she said. Historically, whether to use third-party developers to do that has been open to debate. But she said the hospital has become more receptive to that idea recently due to changes in the financial markets and because third-party developers can help the hospital avoid Stark Law
violations.

(Provisions of the Stark Law regulate physician self-referrals of Medicare and Medicaid patients. Essentially, doctors cannot refer patients to medical facilities in which they have a
financial interest.)

“Because of the Stark regulations, there is an inherent risk with hospitals leasing directly to physician practices,” Ms. Weldy said.

“And if we’re able to still have the office developed in a way that’s consistent with our look and feel, and with our strategy – and at the same time not have to be in the middle of those lease negotiations because we don’t physically own the asset – there’s a big advantage to that.”

Mr. Cozzi agreed that there seems to be a growing receptivity to third-party development and ownership.

“When the tax-exempt bond market started to dry up, we started to see a lot more inbound inquiries from hospital systems and their advisors, from their investment bankers,” he said.

However, while that has led to an increase in development and acquisition opportunities, “I think, again, I’ll have to ask the question: How do you know it’s a good deal?

“Just because we’re seeing more of those, I’m not sure it means that we’re seeing better opportunities.”

Mr. Cozzi said the most critical issue is control. Some potential third-party acquisition deals have unraveled recently because the hospital executives made demands that the buyers couldn’t accept, he said, such as a maximum ground lease of 30 years with no provisions for
extensions.

“So that’s just a non-starter, right? That deal dies because the hospital is expecting a level of control that is just not marketable from an equity standpoint,” he said.

“We won’t buy a building with a ground lease like that and nobody will finance a building with a ground lease like that.”

Hospitals can also make the terms unattractive by trying to include “very favorable purchase options for themselves to buy the building back,” he said.

Mr. Cozzi said hospitals that are serious about third-party development and investment must be willing to give up some control.

Mr. Bodnar said he is also seeing a growing receptivity toward third-party development and investment. Hospital executives are more motivated to accept third-party funds because of
the weak bond markets. However, he added that hospitals need to realize that developers must navigate weaker capital markets as well.

“In years past, the hospital systems would deliver an RFP, and they’d want to see something happen soon – groundbreaking immediately,” he said. “And they have to understand that
the pre-leasing process is different these days. There’s a lot of other contingencies that need to take place before they can get their lenders on board for the projects.”

Cap rates have climbed
When asked about capitalization rates for healthcare real estate, Mr. Bodnar said he is seeing cap rates of 8 percent or more for most properties. “Only for the very best deals are we seeing properties trade sub-8,” he said. That’s up sharply from the cap rates of just a few months ago. “I think on the development side, the cap rates have probably adjusted
a little bit more quickly,” Mr. Cozzi said.

“We’ve seen development yields move in the range of about 150 basis points over the course of the past six months… So, (there has been a) pretty quick and dramatic change in cap rates.”

Asked how the healthcare real estate leasing market has been affected by the recession, Ms. Weldy said Northwestern Memorial has not seen much change in lease rates – although
she said the system’s space might not be representative of the sector as a whole.

But she said she has seen a “pretty significant reduction” in tenant improvement (TI) allowances during the past six to 12 months.

“In addition to that, the biggest change we’re seeing with physician practices is a lot of consolidation,” she continued. Smaller practices are being folded into larger ones, so some
smaller spaces are being vacated while larger tenants are expanding. Overall, she said the hospital’s medical office tenants seem to be holding their own.

“Capital to go into new deals – the money that (physician-tenants) have to spend building up the space above and beyond the tenant improvement allowance – is the No. 1 obstacle
to leasing space to physicians,” Mr. Varney said.

He said Rendina Cos. has tried to address that by referring physicians to regional banks for financing. The firm has also provided additional TI allowances for anchor tenants. Ms. Weldy was asked whether Medicare and Medicaid reimbursement rates are already affecting how Northwestern Memorial does business.

Hospital officials do expect declining reimbursements to continue to put pressure on the organization, she replied. But the hospital’s No. 1 goal is to increase market share, which
would enable it to spread fixed costs across more patients, she said.

“At the same time, though, I think we are looking at cost-reduction
opportunities, just like any smart business does,” Ms. Weldy commented.

“And we’ll have to do that ultimately to protect our growth strategy over the next 10 years. So I do think hospitals are looking very carefully at that.”

Asked what “the smart hospitals” are doing right now to position themselves for success, Mr. Varney said: “The smart ones are looking past the headlines and making plans for growth.” They are not overreacting to the recession and the financial crisis, he said.

“I think the savvy hospitals are looking past that, putting their plans in place, using their finances on their core business, bringing in third-party developers to expand their strategy,”
he said.

“If the hospital executives have a plan, have a vision for growing – whether it’s a patient tower, an outpatient MOB – they need to trust their executives.” He said they should be planning now “because, knock on wood, hopefully things will be over here in a couple of
years or so.”

Providers should take advantage of the depressed construction markets to break ground now for new projects, he said. That way, when those projects come online in a year or two and the economy rebounds, those providers will have a leg up on the competition.

“Healthcare’s doing nothing but growing,” Mr. Varney noted. “So let’s not just put our heads in the sand right now.”

Forging ahead
Asked whether the healthcare real estate business still a good business to be in, all the panelists expressed optimism.

“I still think it’s a great business to be in,” Ms. Weldy said. She said demand is growing and Northwestern Memorial is adding services to satisfy that demand.

“We’re not a speculative business,” she added, “so you haven’t seen us overbuilding… Therefore, our growth is going to have to continue.”

The healthcare industry faces “significant” short-term challenges, Mr. Bodnar said.

“But, long-term, I think it’s a great business to be in,” he said, and a range of socioeconomic trends support that view.

“I think it better be a good business. We’ve got five or six billion dollars invested…,” Mr. Cozzi said.

“We’ve done, just specifically medical office buildings, about three or four hundred million (dollars) over the course of the last couple years, and we’d like to invest another billion dollars in medical office buildings over the next, let’s say, five years. We think it’s a great business long term, and it’s a big, addressable market.”

Mr. Cozzi noted that public companies own about 25 percent of institutional-quality
commercial real estate in other sectors, but only about 10 percent of healthcare real estate, which suggests that there is still plenty of upside.

“So we think that the market is huge – somewhere on the order of magnitude of $150 (billion) or $200 billion worth of high-quality healthcare real estate that’s out there,” he said, “and we’ll be doing this – investing in healthcare real estate – for a long time.”

“I think it’s a great business,” Mr. Varney concluded. “Like anything else, there are challenges. But we just need to dig in and forge ahead because all the statistics are out there for success in the future.

“We just need to get through this short-term blip.”

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