Niche properties

Medical Office Fever

Healthcare development competition heats up.

Sales of medical office buildings topped $6.7 billion in 2013, according to Real Capital Analytics, proof that this niche sector remains attractive to investors ranging from large institutional funds to the medical practice groups that buy their own facilities. Some experts in the field wonder if there will be enough product to meet investors’ needs. Already capitalization rates have reached a six-year low of 7.3 percent nationally, according to RCA data. And only 15 million sf of healthcare properties have been developed since 2011, compared with 41 million sf in 2008 and 2009, according to Marcus & Millichap.

But with the advent of the Affordable Care Act, the rapidly changing healthcare field is affecting many of the factors surrounding MOB development — from location to size to investment funding. And it’s happening faster than before, says Gregory P. Gheen, CCIM, one of the founding members and president of Realty Trust Group in Knoxville, Tenn., which has developed more than $220 million in healthcare projects across the U.S. With more than 24 years of healthcare real estate experience, Gheen looks at current trends occurring in healthcare and MOB development.

What is the biggest healthcare real estate trend today?

Gregory P. Gheen, CCIM: Right now it’s the recent acceleration of healthcare systems’ investment in newer ambulatory facilities being developed off-campus versus on-campus projects. Some hospital planners use the term decanting to describe this fundamental shift in investment from the main hospital campus — typically an urban setting — to new locations in the suburbs. This includes MOBs, cancer treatment centers, ambulatory surgery centers, diagnostic treatment centers, and rehabilitation facilities.

From a real estate perspective, this is quite a change because the on-campus facilities were usually planned and developed by the hospital’s internal staff without a lot of external resources other than architects and contractors. But as you go away from that model, the hospitals are smart enough to know that they need real estate advisers that are knowledgeable about land use trends, traffic patterns, infrastructure, land prices, and rental rates.

What other trends are occurring?

A more-competitive stance among the large healthcare systems: This increased pace to the ambulatory model is being driven primarily by the need to be closer to the patient populations that health systems want to serve to increase market share. But it also improves patient convenience as these facilities are developed in more suburban areas that have better land availability.

Another trend in the last several years is the use of third-party capital to build, finance, and own these new facilities. Historically, the hospital industry relied upon cash, tax-exempt bond issues, or commercial debt to finance facility investments. Today, with all of the competing demands for capital, more hospitals are holding onto their cash and relying on investments by publicly traded real estate investment trusts, private equity partnerships, and institutional lenders. Third-party investors are also becoming more comfortable with new ambulatory facilities being off campus as the investment returns have become almost identical to on-campus projects for facilities with high-percentage hospital tenancy.

With respect to new projects, what trends are you seeing in design layout and size?

There has been a drastic increase in the relative size of new facilities that are offering more-comprehensive medical services under one roof. Several years ago 40,000 to 50,000 square feet was the standard size for a hospital-sponsored MOB, and it usually opened with about 85 percent occupancy — mostly third-party physicians in a multiple tenant building — and filled up within three to four years.

Today, we are seeing projects that are 120,000 to 150,000 sf with about the same occupancy on opening day. But now, all of that space is under one master lease for hospital services and hospital-employed physicians.

Certainly the design team is very instrumental in the architectural process, but from a real estate perspective, this new model affects more than the design. It affects the land analysis and selection process for the land broker, the capital stack and underwriting analysis for the investment adviser, and the selection of the general contractor for bonding purposes for the development manager. Site selection and land acquisition are critical success factors today because healthcare location is much more retail. Analytical models are used to measure demographic opportunities for a health system to pick up market share.

The newer, larger model also tends to consolidate and integrate many more medical specialties into one location. This consolidation creates an opportunity to reposition the older clinics that were vacated by the physicians moving into the new facility. There is little doubt that more existing facilities will become obsolete in the near future as the growing number of hospital-employed physicians are asked to relocate.

Can you elaborate on the physician-sponsored development opportunities?

Many of the development projects that we see are new projects involving a multispecialty group of physicians with all of the doctors under the same group. But sometimes it is a group of doctors from different practices that are coming together into a common real estate project. When they are coming from different practices, one form of ownership that is quite common is the condominium structure where there is separate, fee-simple ownership of each office in the building by the different doctors. When it is a single group of doctors, we are seeing the formation of a special purpose entity — usually a limited liability corporation — with the individual doctors having ownership on a pro-rata basis and the partnership owns the entire building. The partnership retains control of the project, including the sourcing of project debt, and usually has a board comprised of physicians that rely upon a third-party property management firm to run the property operations, management, and accounting.

In recent years, we have seen more disparate groups coming together and offering different services such as a large primary care practice in the building with an allergist, dermatologist, and a “time-share” office where a cardiologist and rheumatologist may rotate through on a regular set schedule. This model does two things: It helps disperse a broader mix of services out into submarkets and it is a very cost-effective real estate strategy because the doctors are able to spread the facility overhead.

What’s the difference between developing for a physician group and developing for a hospital?

Overall, for any MOB, the development cycle is probably going to be a little longer than other non-medical projects. When the client is a hospital, there are many stakeholders that will be involved, and receiving their input is critical to the success of the project. This will include hospital administration, clinicians, physicians, and support personnel like the infection control department that monitors air quality during construction. Physician-sponsored projects are typically somewhat faster for the development cycle, but the financing strategy may be a little more complicated than the hospital-sponsored project if the financing involves multiple physician/owners.

But I think it is important, as a developer, to allow physician ownership either through a real estate partnership or some other structure if the medical tenants want to be investors. Facility decisions are long-term commitments and sometimes they would prefer to pay rent to themselves.

Is leasing medical real estate much different than leasing general office space?

Yes, it is fundamentally different. Medical office space can be much more expensive to build out than general office, so the real estate adviser to the landlord and investors needs to factor this into the investment analysis. The tenant may elect to make an equity investment in the tenant improvements if the allowance in the lease does not cover all of the costs, thereby holding down the landlord’s commitment. But the adviser should model a full capital contribution scenario in the cash flow pro forma and review the impact of the tenant’s contribution with the landlord/investor.

A second difference is that, depending on the parties to the lease, the transaction could be covered by federal regulations that provide certain restrictions on the transaction economics. Simply put, there is an inherent requirement that a transaction between a hospital and a physician be at fair market value for the rental rate and that other terms be commercially reasonable. (See below.)

Physician/Hospital Leases

Real estate transactions within the healthcare industry can involve a wide variety of legal and regulatory issues. An apparently simple office lease between a physician group and a hospital or the sale of land and building between the two parties can quickly run afoul of the Anti-Kickback Statute and Stark Law, or both.

The AKS provides for criminal penalties, civil money penalties, and possible exclusion from federal healthcare programs such as Medicare and Medicaid. It is an “intent-based” analysis evaluating whether the parties were consciously trying to induce or reward referrals. As such, while the AKS regulations contain safe harbors delineating arrangements that will be deemed not to violate the statute, the failure to meet a safe harbor does not mean that the transaction violates the AKS. Again, the element of “intent” must be present.

Stark, on the other hand, is a “strict liability” or mechanical analysis of the financial arrangement (lease agreement or sale transaction) between the parties, and receives much more attention from real estate practitioners because the law can be violated, without intent or knowledge, if the parties do not fit the transaction with an applicable Stark exception and meet each and every element of the exception.

The Stark exception for office leases generally includes:

• the lease is in writing, specifies the premises, and is signed by both parties;

• the lease is for a term of at least one year;

• payments are made in advance and are consistent with fair market value in an arm’s-length transaction;

• the premises should be used exclusively and are reasonable and necessary for the legitimate business purpose of the tenant;

• rental rate is not determined in a manner that takes into consideration the value of any referrals or other business between the parties; and

• the agreement would be commercially reasonable even if no referrals were made between the parties.

A qualified real estate professional can provide an independent and objective opinion to satisfy the exceptions — especially with respect to fair market value of the lease rate and the commercial reasonableness of lease terms. In providing this fair market assessment, the broker should be knowledgeable of the healthcare real estate market with respect to comparable properties including medical and non-medical buildings and understand the terms fair market value and commercially reasonable, as they are defined in the applicable regulations and statutes.

In addition, a healthcare real estate attorney should be consulted on these matters. — Gregory P. Gheen, CCIM


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