Office

A Healthy Prognosis

Medical Office Buildings Offer a Prescription for Opportunity.

As the health-care industry continues to evolve in the wake of a growing number of managed-care facilities and closer attention to the bottom line in the medical profession, the property niche of medical office buildings (MOBs) also continues to change. New ownership structures, the redevelopment of facilities, and consolidation into larger practices are some of the trends influencing the real estate needs of medical communities. Commercial real estate professionals intent on serving this niche can discover opportunities in sales, site selection, development, and real estate investment trust (REIT) acquisitions.

Short-Term Prospects
Real estate professionals likely have a three- to five-year window of MOB sales opportunities. Confidence in the economy, less talk about complete health-care reform, favorable interest rates, and increased values and sales have given this niche a healthy transfusion of activity.

Leasing of health-care facilities also promises to be robust during the same period at strong hospital campuses and in newly developed communities. The length of lease terms should average three to seven years, which shows a return of confidence among hospitals and health-care professionals.

Ultimately, patient care drives most of the physical needs, tenant improvements, and access/parking issues for medical property users. For example, a typical medical practice requires approximately 800 square feet (sf) to 1,000 sf to accommodate a single doctor. One office and two to three exam rooms per doctor is a good rule of thumb. For certain specialists, a procedure room also is necessary.

Understanding patient flow is of critical importance: Mixing the parking, entry, and/or lobby of a cardiology or oncology clinic with, for example, a pediatric clinic could be problematic if children become fearful of visiting the doctor because chemotherapy patients are sitting across from them in the waiting room. Knowing which types of practices are compatible in certain areas or on the same floors is crucial and can drastically affect tenant retention and, as a result, the real estate investment’s performance.

Medical Real Estate
The two main categories of medical real estate are hospitals with attached or adjacent MOBs and stand-alone MOBs that typically are one- to two-story walkups. A building attached or adjacent to a hospital normally is considered "on-campus" and buildings in the community normally are considered "off-campus." Each type has its own market considerations.

On-Campus MOBs. On-campus buildings rely heavily on their affiliated hospitals for leasing referrals. The demand for on-campus MOBs can vary dramatically, depending on the financial health, census (the occupancy percentage of the number of patients a hospital has admitted on a given day), utilization, and management of the hospital. Health-care industry experts at a recent Health Care Facilities Institute conference predicted that 20 percent to 30 percent of U.S. hospitals will close or undergo a radical use change within the next two years. This could cause a substantial decline in demand for on-campus buildings. In many cases, even a rumor that a hospital may close, be sold, or change uses can have the same effect.

Before brokers list an MOB to lease or sell, they should research the status, ownership, and goals of the nearest hospital. By targeting hospitals with financial stability, good community reputations, and physician-development programs that actively recruit new physicians, brokers and leasing agents can increase the likelihood of success.

Off-Campus MOBs. Off-campus MOBs have suffered the most from health-care reform. Many of these buildings, constructed during the 1970s and 1980s, are not suited for the changes associated with managed care rules, consolidation, and retrofitting to comply with the Americans with Disabilities Act (ADA). These one- to two-story structures range in size from 5,000 sf to 20,000 sf, with a common suite size of 1,200 sf to 1,800 sf, which fits one or two physicians.

Today’s health-care providers are looking for significantly larger suites of approximately 2,200 sf to 5,000 sf, which means older-MOB owners must consider the cost of retrofitting. Combining two or three older suites to accommodate a large medical group could cost between $35 per square foot (psf) and $65 psf. If a landlord amortizes this improvement cost into the lease rate using a 9 percent cost of money over a five-year lease term, the impact to the rate will range from $0.75 psf to $1.20 psf per month. Most owners of existing MOBs, depending on the geographic area of the country, will offer tenant improvement allowances of $10 psf to $15 psf. The additional tenant improvement cost usually is covered by increased rent or paid by the physician/tenant.

Because of off-campus MOB limitations, many hospitals and medical groups that seek a presence in the community lease space in other property types such as shopping centers and former banks, restaurants, and convenience stores.

Physicians, too, who once occupied space in off-campus MOBs are consolidating and moving into larger spaces with other physicians to cut overhead and streamline operations. This affects vacancy rates in off-campus MOBs, leaving brokers and building owners facing re-leasing.

MOB Ownership
Ten years ago, hospitals owned most on-campus MOBs and physicians owned the off-campus MOBs they occupied. Today, ownership is much more diverse.

Currently, most on-campus MOBs still are owned by their affiliated hospital. However, more and more are being purchased by REITs, which are leasing the buildings back to hospitals on a net lease. In some cases, REITs also will provide building management and leasing. Selling to a REIT is attractive to some hospitals because REITs promise to turn a medical office building into capital that can be used for core functions and services like the purchase of new medical equipment. Some health-care systems are open to this concept, but it is still a tough sell to a conservative board of directors that usually is concerned with giving up control of its on-campus real estate.

Ownership of off-campus buildings also has changed. For instance, in the 1970s and 1980s, tax advantages and the promise of equity popularized condominiums, in which physicians owned their practice suites. However, as these physicians retire or consolidate, they often are unable to sell or lease their condominiums because physicians often need to be flexible with regard to their space, which ownership would restrict.

Also popular were limited partnerships in which physicians were tenants. In this case, tenant/physicians often paid higher-than-market rents to enhance their investments’ value. When physicians retired or tried to re-lease the space, the market couldn’t bear the rate they were paying.

Today, many of these buildings have gone into foreclosure or receivership and have been good buys for REITs. Local investors who have an interest in the health-care real estate niche also are acquiring them.

Real Estate Opportunities
MOBs offer several types of opportunities for commercial real estate professionals.

Site Selection and Land Acquisition. Site selection and land acquisition work will require close alliances with hospitals and health-care systems that are expanding into suburban and rural growth areas that have limited health-care access.

In addition to health-care systems, skilled-nursing operators are building seniors housing and assisted-living facilities nationwide and currently are acquiring numerous sites. (See "Seniors Get an Assist," CIREJ, July/August 1998.)

In newly developed communities, hospitals that serve the area may consider putting a 2,000-sf to 5,000-sf clinic in a highly visible location, such as an outpad of a new shopping center. However, shopping center developers rarely incorporate medical clinics into their construction pro forma statements, parking requirements, or overall plans. In addition to convincing retail developers about the merits of putting a clinic in a center, brokers involved in such arrangements must prepare hospitals for higher lease rates and minimal tenant-improvement allowances.

Developers who want to include a medical clinic in the overall plan of a shopping center should seek the two hospitals nearest the center and offer to build to suit. Average lease terms could last from three to five years, with occasional 10-year leases in cases in which the tenant needs to amortize a large amount of tenant-improvement dollars or wants to protect its location and investment.

Depending on how the area’s health-care needs are served, one to three hospitals may be competing in the same service area. However, typical site selection rules do not apply to MOBs. Since patients under contract-care and managed-care arrangements must visit their specified health-care providers, clinics are not really competing against each other for all target customers in the area. Thus, it is possible for two competing clinics to be located just blocks away from each other.

Such issues also affect the need for signage, access, and other elements associated with retail sites. The majority of patients do not choose a health-care clinic based on the physical characteristics of the property because they may have little choice about where to access care.

Development. With some exceptions, hospitals and developers are building fewer on-campus MOBs as a result of the shrinking physician population and the overbuilding that occurred in the 1980s. However, in areas where population growth is high and overbuilding did not occur in the previous decade, development remains brisk.

Instead, hospitals and building owners are converting existing buildings, where possible, to address new health-care delivery trends. For instance, as most hospitals focus on outpatient business, MOB developers, architects, design/build firms, and contractors have created a boutique industry of redesigning hospital entrances and outpatient service areas.

Real estate professionals also are serving hospitals that do not meet ADA requirements by assisting with the complete redesign and construction of entire campuses. In some of these cases, new MOBs are designed to accommodate outpatient hospital services on lower floors and physician offices on the upper floors. A popular term for this MOB type is "center of excellence."

The managed-care industry also has affected MOB development. For example, some managed-care companies have closed managed-care facilities as patient trends and contracts for care have changed hands. This has slowed the development of new managed-care facilities.

With the increased availability of hospital beds, many managed-care companies are forming alliances to contract for beds at area hospitals, rather than constructing new managed-care hospitals. In addition, they lease space in on- and off-campus MOBs of 5,000 sf to 10,000 sf per site. This enables the company to reach out to the community at numerous points of access, rather than at one large, expensive facility.

REITs. About 13 public REITs specialize in medical real estate. They are most interested in skilled-nursing facilities, hospitals, and MOBs. In almost every case, REITs prefer to buy master-leased buildings where they can purchase both the land and improvements on a fee basis. However, in the current demand-driven market, a surplus of class A buyers has pushed REITs into the class B and off-campus markets. In addition, more REITs have acquired multitenant buildings without master leases in the last 12 months. This market activity increased property values, helping brokers to convince owners to sell.

Brokers offering acquisition services to REITs should be proficient in all types of medical properties. Unfortunately, most skilled-nursing operators and hospitals are not used to paying a broker to market their facilities. To overcome this hurdle, brokers must be familiar with local MOB market conditions and demonstrate the worth of their expertise to potential clients.

Leasing. Leasing agents often face some unique challenges when negotiating with doctors who occupy MOBs owned or master-leased by hospitals. In many cases, the doctor/tenants have staff privileges with the hospital/landlords and can gain the ear of the hospital’s administration on the clinical side. This circular relationship makes it difficult for the leasing professional representing the hospital to negotiate leases with doctors who support the hospital through their patient referrals.

The Internal Revenue Service’s Stark II law essentially restricts hospital/landlords from competing for doctor/tenants by offering below-market rental rates or more favorable lease terms. Savvy real estate professionals can use Stark II as a tool to bring market averages into the negotiations.

Managed care also has influenced lease structures for medical properties of virtually every type, manifesting itself in consolidation of practices, early retirements, large organizations buying smaller practitioners, and strategic alignments of primary care doctors and specialists—all in an effort to control costs.

Over a five-year lease term, for example, tenant improvements may need to be altered to accommodate contraction or expansion of a particular medical tenant. Modular workstations, mobile walls, easy-to-relocate electrical outlets, plumbing locations, and other flexible systems are necessary for changing times in medicine.

Doctors themselves are fearful of change, too, and requests for early lease buyouts or early termination language in medical leases are common under a climate of change.

A Diagnosis for Success
Change continues to permeate U.S. medical communities and thus continues to affect the real estate associated with hospitals, skilled-nursing homes, and medical centers. A few trends are here to stay: It is doubtful that managed care, consolidation, and concern with fiscal performance will dissipate. Yet the professional side also continues to change. The growth of hospices, home care, and alternative health care, along with new methods of patient care and service delivery, will continue to affect the real estate needs of this viable property niche.

Garth E. Hogan and Tom Hoban

Garth E. Hogan is president and CEO of Medical Realty Advisors in Newport Beach, California, which specializes in health-care brokerage, management, and advisory services and manages real estate in excess of 2 million sf for more than 20 hospitals. Contact him at (714) 719-1880 or ghogan9021@aol.com.Tom Hoban is president and CEO of Coast Management Company, Inc., in Everett, Washington, which specializes in management, leasing, and advisory services for medical office buildings in the Pacific Northwest. Coast’s portfolio includes about 1.5 million sf of commercial and medical space. Contact him at (425) 339-3630 or shawnhoban@coastmgt.com.

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