Office CCIM Feature

Medical Office Trends

Hospital affiliation is a strong indicator of MOB asset value.

By Patricia Wassik, CCIM, CPM, and Deborah Carlson, CCIM, CPM |

The U.S. demand for medical services is expected to skyrocket over the next decade due to demographic trends and new healthcare legislation. As baby boomers retire, the over–65 age bracket will grow by 36 percent and that age cohort traditionally consumes three times the medical services of younger people. Additionally, under the Patient Protection and Affordable Care Act, signed into law in 2010, 32 million additional Americans will have health insurance. This represents an 11 percent increase by 2019, according to an Urban Land Institute report. Job creation among healthcare practitioners will likewise mirror this expanded patient base.

These and other factors will increase the demand for medical office buildings by 19 percent by 2019, according to ULI. The need for an estimated 64 million square feet of additional MOB space in the coming decade dwarfs the 6.3 million sf that will deliver this year. Therein lies the conundrum of the MOB market: As vacancy rates dip below 11 percent and occupancy tightens, development is moribund. Why does a cautious attitude afflict the office market's strongest subsector?

Physicians vs. Hospitals

In addition to broader economic factors affecting all commercial property types, healthcare real estate is impacted by increasing levels of regulatory compliance; in particular, PPACA was upheld by the U.S. Supreme Court in late June. This legislation has fostered significant marketplace uncertainty, profoundly influencing how tenants (physicians) and MOB owners (hospitals and equity investors) are approaching their real estate decisions.

Physician practices are hedging their options by "waiting it out" and taking more–measured, conservative approaches to their MOB space requirements. Specifically, healthcare tenants are frequently remaining in place, minimizing relocations and facility expansions, and opting for shorter–term lease renewals of 12 months to 24 months. Their approach is predicated upon the numerous unknowns of healthcare reform: anticipated decreases in insurance reimbursements, increased compliance costs, and the reality they may soon become salaried employees of larger healthcare systems.

Conversely, hospitals and affiliated health systems are operating as if healthcare reform will proceed either partially or wholly intact. These entities frequently have large geographic footprints, own significant real estate portfolios, and cannot afford a wait–and–see approach, given the need for longer lead times and bureaucratic realities of large organizations. Generally, hospitals are taking a more aggressive posture, pushing forward with distributed networks of healthcare facilities. Well–located MOBs, strategically positioned throughout patient communities, are highly desirable as they can achieve operational efficiencies and lower operating costs.

Yet, physicians' and health systems' real estate requirements for hospital–affiliated MOBs are converging due to increasing numbers of hospital–employed physicians. With the uncertainties surrounding healthcare reform, this trend provides mutual safety and economies of scale. Physicians gain the security of a consistent salary and lose the cost of tracking down third–party payments and covering insurance risks singlehandedly. Conversely, hospitals gain increased market share and improved cost containment.

MOB Asset Value

As more physician practices move to hospital ownership, an MOB's hospital affiliation, or lack thereof, is an increasingly important indicator of asset value. From the perspective of MOB investors, hospital affiliation may provide greater overall tenant stability and credit ratings as the hospitals themselves become the lessees. This trend is enhanced by healthcare systems' push for strategically located MOBs to form the backbone of their increasingly dispersed facility networks. In addition, real estate investment trusts and institutional investors, which accounted for 45 percent of 2011 MOB sales volume, specifically target health system–affiliated properties. Therefore, the investment community, physician tenants, and capital market participants increasingly favor hospital–affiliated MOBs.

Hospitals, in recent years, have gravitated toward the prospect of MOB ownership; however, their perspective in many cases may be shortsighted. In essence, they own the practices/occupants, so why not own the real estate? Some argue that hospitals have purchased and sold physician practices in the past and the pendulum will again swing away from owned physician practices, making long–term real estate decisions based upon short–term trends a costly mistake.

The recurring uncertainties of healthcare reform have curtailed physician–owned development projects over the past few years. Physicians continue to look for more flexible and fluid occupancy alternatives, with shorter–term lease options providing the desired flexibility. The same uncertainties have also affected the investment market for physician–owned, non–affiliated properties. Due to institutional investors' requirements for creditworthy tenancy, private investors with greater risk tolerance encounter infrequent competition from institutional investors for non–affiliated MOBs.

Additional Opportunities

In addition to MOBs, other non–medical real estate properties are becoming important components of hospitals' comprehensive approach to building networks of healthcare facilities. In particular, spaces and pad sites within well–located retail centers are forming health systems' increasingly brand–specific, front–line facilities.

This shadow space effect seems to have some appeal to both physicians and hospital–affiliated practices. These users are particularly taking advantage of smaller spaces, ranging from 10,000 sf to 20,000 sf, that were formerly occupied by banks, video stores, and furniture stores. Cost–effectiveness together with the abundant parking ratios of many retail facilities can provide an economical space option for healthcare users. Additionally, the access, visibility, and branding opportunities of these retail sites offer healthcare providers a much–needed competitive advantage.

CCIMs can benefit by embracing the role of ongoing, trusted adviser to hospitals and physician practices alike. Specifically, CCIMs can help protect and enhance the MOBs' underlying asset valuations by validating fair market value lease terms as well as navigating the potential impact of lease accounting changes. These proposed changes will place real estate leases onto hospitals' balance sheets, thereby increasing reported occupancy expenses. Healthcare organizations will be required to recognize both liabilities for future rent obligations, and assets reflecting their right to utilize the underlying real estate. Additionally, hospitals that own land but not the real estate residing on it may have to account for these properties as both assets and liabilities. The net impact to hospitals' perceived financial performance could be significant and influence their credit ratings.

There are significant advantages to specializing in healthcare real estate in a mature secondary market. Midsize markets are large enough to support specialization and encompass significant MOB inventories that attract local and regional investors as well as institutional capital, including large REITs. This broad investor cross–section provides opportunities to work with and represent a variety of owners with varying investment objectives. These relationships, in turn, enhance healthcare tenant advisory services.

Some of the greatest opportunities and challenges for a healthcare real estate firm include expanding geographically to other metropolitan areas. In particular, tertiary markets are a compelling opportunity. Service providers in smaller markets frequently cannot afford to specialize, which allows a larger more–specialized company to bring significant expertise in healthcare–related property management, property marketing and leasing, tenant representation, buyer and seller representation, and acquisition and development consulting to otherwise underserved markets.

Patricia Wassik, CCIM, CPM, is president and Deborah Carlson, CCIM, CPM, is chief operating officer of Health Connect Properties, a Denver–based healthcare–related real estate services firm. Contact them at pwassik@healthconnect properties.com and dcarlson@ healthconnectproperties.com.