Medical Office Buildings: Vital Signs Fairly Stable in Sickly Market
Deal Volume Has Dropped But Long-Term Demographics Continue to Favor Medical Office Investors
One of the major marketing claims developers made to investors regarding medical office buildings (MOB) is that they are "recession-proof" -- immune from the wild swings of market cycles that plague other property types due to their limited supply, the steady growth seen in health-care employment, and the oncoming wave of aging baby boomers sure to need medical care for the next few decades.
And while it's become apparent that no property type is truly recession-proof, it certainly appears that MOB is recession-resistant. Sales activity has slowed, but far from come to a crashing halt as has occurred for other property types over the last two quarters. Overall transaction volume is down due to the debt crunch and higher equity demanded by lenders to finance deals. The MOB transactions that make it to the finish line are also smaller. Single- and multi-tenant office space flagged as a medical use, excluding bulk portfolio sales, dropped from $3.14 billion on 881 transactions in fourth-quarter 2007 to $1.5 billion encompassing 663 deals in fourth-quarter 2008, according to CoStar COMPS data. CoStar is still capturing sales data for the first quarter of 2009, but preliminary figures point to another drop in the number and dollar volume of deals.
A review of CoStar COMPS data shows that since late last year, most transactions have involved smaller assets sold by individual owners. However, a few portfolio deals have closed, including the sale by Carolinas Healthcare System of 15 medical office buildings in the Charlotte area totaling about 750,000 square feet to Nashville-based Healthcare Realty Trust Inc. (NYSE: HR) for $162 million in a deal that closed at the end of the fourth quarter.
"The lack of available credit and ongoing financial turbulence will likely limit the number of MOB transactions in the near future," noted Healthcare Realty Trust Chief Operating Officer Doug Whitman. "We have begun to see cap rates increase somewhat, although the decline in deal volume will hamper any transparency in rate. We are certainly seeing an increased number of attractive acquisition opportunities, diversified in geography, deal size, and type of seller, but the frenzied competition to complete transactions has vanished."
That said, medical office portfolios continue to perform well, with sound operating fundamentals, stable occupancy and increases in renewal rental rates, owners, developers and brokers said. With a fairly good balance between supply and demand, overall vacancy rates have fluctuated between 9% and 12% over the last several quarters -- though they are currently at the upper end of that spectrum.
Physicians: Higher Costs, Fewer Patients
Neil Sorkin, senior commercial advisor with Prudential CRES/IPG in Las Vegas and a medical office specialist for nearly 20 years, said as in previous downturns, most physicians are holding their own against economic headwinds. But unlike previous cycles, many doctors in Nevada, Arizona and California report that their daily patient counts are down anywhere from 15% to 25%.
Others, especially those that jumped onto the medical office condo bandwagon a few years ago and bought their own building, are now opting to sell and lease back their space because they’re not equipped to handle ongoing maintenance and operations.
"I’m hearing more from doctors that thought it was a good idea at the time, but now it’s not," Sorkin said. "And many are scaling back their practice and subleasing 2,000 square feet of a 6,000-square-foot building, or selling their space and leasing it back from the investor."
Healthcare Realty Trust CEO David Emery remains bullish on the sector based on four decades of economic data.
"Despite a difficult economy, outpatient medical office continues to be resilient," Emery said. "Since 1972, through six recessions, physician office employment has grown annually by approximately 4.8%, compared with the national private employment growth rate of only 1.8%.
"We view healthcare employment as the best indicator of demand for facility utilization, and our managing of our expectations of lease rates and the time necessary to lease up new buildings."
Investors polled for the PricewaterhouseCoopers Korpacz Investor Survey last month said lenders on MOB transactions once required 20-25% equity on a 10-year borrowing note, but now demand 30-35%.
"There is not much new business out there. A lot of smaller, value-add, bottom-of-the-barrel deals exist, but we have not seen a good solid deal come out since the third quarter of 2008," one investor noted.
However, medical office transaction volume appears to be holding up relatively well compared with commercial property sales overall. Despite the sales deceleration, overall average cap rates for MOB space edged up a mere 3 basis points in the first quarter, compared with an average 30-basis-point increase for each of the individual office markets in the Korpacz survey.
Prudential CRES's Sorkin said on the whole, the first quarter of 2009 has seen a slight uptick in sales and leasing activity in his markets after a "completely dead" fourth quarter. He predicts a gradual strengthening through the rest of the year.
Raising Funds for Future Acquisitions
Grubb & Ellis Realty Investors LLC, sponsor of Grubb & Ellis Healthcare REIT, Inc., offers another barometer of the niche sector’s overall health. The Santa Ana, CA-based company demonstrated its confidence in the MOB market last month by announcing its plans to launch a second non-publicly traded REIT, Grubb & Ellis Healthcare REIT II Inc. Grubb & Ellis, which filed a registration statement for the new REIT with the SEC on March 9, hopes to raise more than $3 billion to invest in single- and multi-tenant healthcare and MOB properties.
Although its acquisition activity has slowed in the first quarter overall, Grubb & Ellis Healthcare REIT, Inc. on March 5 announced the $34 million acquisition of a Wisconsin medical office buildings portfolio of four fully leased buildings in the greater Milwaukee area, from Aurora Healthcare in a sale-leaseback transaction. The portfolio includes 185,000 square feet encompassing buildings in Menomonee Falls, Milwaukee, Richfield and Mequon.
Early in the first quarter, Grubb & Ellis Healthcare also announced the acquisition of the two-property Mountain Plains MOB portfolio in San Antonio, TX, and the Houston suburb of Webster for $43 million; and the acquisition of Marietta Health Park, a four-story, 81,000-square-foot MOB located adjacent to WellStar Kennestone Hospital in Marietta, GA, for a reported $17.3 million. Both deals closed in December.
Following is a list of other large medical office transactions that have closed or under contract so far this year compiled from CoStar COMPS and other sources:
- On Jan. 20, MOB Realty Trust sold a 50,000-square-foot medical office building to Senior Housing Properties Trust for $19.3 million, or $386.00 per square foot. The deal was one of a series of transactions that started in July 2008 and are scheduled to finish in May 2010, involving the acquisition of 48 medical offices, clinics and biotech laboratory buildings by Senior Housing Properties for $565 million. The transaction includes a total of 2.18 million square feet of properties in 12 states. The portfolio is stabilized, with current average occupancy of 98.3% and 370 tenants with an average remaining lease term of 6.7 years. The cap rate on the deal is about 7.9%.
- Aurora Healthcare Inc. acquired the medical office building at 3111 W. Rawson Ave. in Franklin, WI, from Medical Specialists LLC for $16.98 million, or about $237 per square foot. The two-story, 71,532-square-foot facility was built in 2002 in the Milwaukee Southeast submarket. Both parties were represented in-house.
- New York-based Concourse Realty Associates bought Stoneterra Medical Plaza, a 57,211-SF medical building in San Antonio constructed in 2006, from San Antonio Orthopaedic Group LLP in a deal valued at $13.7 million. The property was fully occupied at the time of the sale with no major lease rollovers until 2017. All tenants are on triple-net leases with options to renew. Alex Zylberglait and Ryan Shaw of Marcus & Millichap represented both sides in the transaction.
- Gyrodyne Company of America Inc. agreed to purchase Fairfax Medical Center, a 59,108-square-foot medical office property with 28 tenants at 10721 Main St. in Fairfax, VA, for about $13.2 million. Gyrodyne expects to complete due diligence and close on the deal by April 30 for the property adjacent to a surgical center owned by Hospital Corp. of America.
- Noyack Medical Partners LLC acquired a medical office condo at 220 E. 65th St. in New York for $13.25 million, or $662 per square foot, from Ivy League Medical Realty Corp. The 20,000-square-foot condo is Concorde Apartment building in the Plaza District Submarket.
Sorkin noted that the southern and southeastern markets, including Texas, Georgia and some parts of Florida, are faring relatively well, while the southwest and West Coast markets in Arizona, Nevada, California, Oregon and Washington are struggling. He noted that some markets, including the southwestern submarkets in the Las Vegas metro area, are suffering from temporary oversupply.
"Right now, without question, we’re in a tenant market, but it’s not going to last long. We’re telling tenants they should do a five-year deal now and get locked in at a low interest rate if they can, and take advantage of free rent, relocation and tenant improvement allowances.
"The biggest problem doctors have is their TI costs, which are higher than other types of build out," Sorkin said. "Before the recession, landlords would give tenants $35 or $40 a foot for build out and the doctor would have to figure out how finance the balance, even on a lease deal.
"Now, owners are saying they’ll give $80 a foot if they have to."