Office

MOB Diagnosis

Understanding Doctors' and Patients' Needs Will Help Drive Successful Medical Office Development.

Few commercial real estate niches have changed as much during the last 30 years as medical office buildings. The same factors that have driven health care to the brink of nationalization and back have caused MOBs to adapt as well.

Going forward, an aging population means that MOB prospects are good if real estate professionals understand what health-care users truly demand from medical facilities. Considering the amenities that older health-care users look for and desire will direct MOB developers and leasing agents toward buildings that incorporate patient needs in their design and layout.

Beyond that, understanding physicians and medical administrators' space needs can help commercial real estate professionals unravel some of the issues related to the medical field's future use of real estate.

Responding to Change The biggest change to hit organized medicine in the past 10 years is managed care. For better or for worse, the guiding principle of managed care puts greater emphasis on the bottom line, which translates into containing costs while attracting patients. This has led many hospitals to market their facilities directly to patients, instead of relying on doctors' referrals as in the past.

In the same vein, many doctors are driven to consolidate in order to capture economies of scale while retooling to offer the more-lucrative procedures and tests formerly performed in hospitals. More-expensive medical space on hospital campuses and near research centers may be left only for specialists who perform high-revenue procedures, which already has happened in some areas.

Medical professionals such as internists, family practitioners, and pediatricians ultimately may not be candidates for class A MOBs, while specialists such as cardiologists, neurologists, and oncologists will continue to demand such accommodations.

Real estate professionals involved with the development of outpatient surgical facilities will find an increasing number of doctors who need such facilities, as joint ventures between hospitals and surgeons become more popular. New technology, as always, will place demands on developers and building owners for state-of-the-art buildings where physicians can gain competitive advantages and attract new patients with new procedures.

In some markets where health-care and related research are among the top few employers, MOB demands will remain strong. In more competitive areas, MOBs must be tailored to meet local health-care demands.

Here's how various types of MOB space are evolving.

MOB Structures Medical office property segments face different development and leasing issues depending on where they are located.

On-Campus Facilities. Naturally, health-care professionals may find MOBs on hospital campuses attractive. Reasons include physician convenience, the ability to use hospital services such as X-ray, laboratory, or MRI facilities, and prestige for doctors on the hospital staff.

For these types of MOBs, hospitals often will not transfer the land, so long-term ground leases frequently need to be negotiated. By leasing the ground, hospitals can retain some control over certain uses of the property.

This may not affect a building's value, though owners need to monitor the expiration date of the ground lease. Lenders may be hesitant to refinance existing buildings if the term is not at least 30 years.

On crowded hospital campuses, parking is often an issue that MOB owners must clearly and precisely define. Many times, on-campus MOBs enter into shared parking arrangements with hospitals.

On-campus and other medical office developers should consider some special parking circumstances. Physicians may make relocation decisions based on parking cost and convenience. First, many doctors prefer reserved, convenient parking — and often demand it. Second, many physicians don't want patients to pay high parking rates, and many patients prefer surface parking or simple parking structures.

Off-Campus Facilities. Many newly developed off-campus MOB facilities have revolved around specialists with ownership in the building. According to many health-care professionals, facilities that focus on specialty groups have the best chance to thrive. For instance, a 100,000-square-foot facility with a cardiology group, an oncology practice, a gastroenterologist, and an orthopedic practice located minutes from a major hospital may fare well. Such practices could contribute to the building, designing lab, X-ray, MRI, pharmacy, or other related space. Each practice might play a role in running the ancillary services and participate in the profits.

“Finding specialists that share similar services and co-locating those services within the building is a great strategy” for MOBs, says Phyllis Brown, practice administrator for Arkansas Cardiology in Little Rock. A large practice can anchor a facility and be an effective recruiting tool to attract other practices to the building. While this often is successful, it should give way to a medical partnership facility.

Managed care has motivated physicians to find ways to capture income that traditionally has been contracted out. Larger practices are looking for ways to take procedures out of hospitals and labs and keep them in-house. The convenience of the one-stop medical facility helps physicians recruit patients as well, which in turn helps keep buildings profitable and attractive to medical tenants.

While many practices expand to shed overhead and endure lower fees gained from HMOs, demand also exists for small, conventional medical practices such as specialists who work alone or young physicians who begin a practice with a staff of two. Spaces of 1,000 sf to 1,500 sf are easier to lease when conventionally designed. A typical design includes a small waiting area that can accommodate two to four patients, two to three examination rooms, a physician office, and a reception area.

Ambulatory Care Centers. Few elements have changed in health care as drastically as surgery. Less-invasive procedures mean shorter recovery times, and outpatient surgical centers, or ambulatory care centers, have exploded in the last decade.

Many newer buildings with combined practices are centered on the concept of surgery or procedure rooms where patients can be treated without overnight stays.

Health regulatory agencies, such as state health departments, will play a role in defining the costs of developing such facilities, as they are more highly regulated. Developers should take special note of the costs associated with Medicaid-approved facilities. If a developer or building owner provides most of the build-out and is promised yield through higher rents, it is extremely critical to make sure the tenant is an established practice or health-care organization. Developing any surgical center is direct competition with area hospitals, which need procedures performed in their facilities to exist.

Ambulatory care center owners and developers should calculate the rent needed on the space, surrender a fair tenant finish allowance for typical medical office space in the market, and amortize the rest over the lease term. They should create a formula to amortize the cost above the tenant-improvement allowance, since total costs are likely to fluctuate during the construction period.

Developers also should consider a construction contract with a guaranteed maximum price; doctors or regulatory agencies may mandate changes after the design phase is over and construction begins.

Making Older MOBs Attractive Older MOB properties face a variety of challenges. For instance, a 20- to 30-year-old facility may have outlived its once-prime location. However, unlike retail and office, medical care is needed in every area and every demographic cross section, so location may not be as critical as long as the area is safe and convenient.

The cost to rehabilitate older MOBs has left many such spaces obsolete and without redevelopment potential. Where extensive remodeling is needed, asbestos levels in older buildings can be a crucial factor. In states and cities where sprinklers are a mandated retrofit, asbestos abatement in ceiling tile and applied fire retardant leaves the building owner without a justification for continuing medical use.

In addition, Americans with Disabilities Act requirements clearly are more closely scrutinized in MOBs. For instance, public restrooms may not be large enough to accommodate ADA turning ratios for wheelchairs and stall sizes. A building acquired or leased with major rehabilitation in mind should factor in a 20 percent to 40 percent add-on for ADA upgrades.

Medical buildings also will be held accountable to fresh-air-intake laws and many occupants, being health-care professionals, may know about “sick” buildings. Older MOBs also may face parking problems if densities have increased over the years.

Converting typical medical office use to non-typical use such as removing office space in favor of open space can be risky if the lease does not carry at least a five-year term. Most medical office users prefer typical medical space. MOB leases in markets where the landlord is expected to contribute to the fit up should budget for larger tenant finish allowances if spaces in a facility are not standard in design.

While some MOB redevelopments are economically feasible, many owners focus on making these facilities as attractive and efficient to operate as possible, while keeping them as medical facilities. Some redevelopments have centered around assisted-living concepts or government-subsidized medical research programs and studies. However, most owners of older MOBs develop long-range plans that include keeping the use the same and trying to meet as many market demands as possible. Thus, 20- to 30-year-old MOBs, like other commercial properties, will find lower rental rates can help offset some of the building's perceived drawbacks.

Ownership Options Over the years, medical office condominiums, or horizontal property regimes, have been a popular means of transferring ownership from developers to MOB tenants. Medical office condominiums are an efficient option for practices that need to own their space.

Transferring a condominium is easier than selling an interest in a limited partnership. From a developer's standpoint — especially one that later will manage the facility — significant opportunities exist for brokerage and leasing fees that can be earned from periodic sales and leases. Medical office condominiums are governed by a board of owners that often leave day-to-day facility management to a third-party company. However, high-rise medical condominium owners should be aware of higher-than-usual maintenance costs; operating costs for high-rise MOBs can range from $6 per square foot to $13 psf annually, often with little discount for unoccupied suites.

Another effective way to develop MOBs is to form a limited liability company where the developer is the managing partner or general partner and a group of physicians occupies the building on long-term leases. Lenders often find this arrangement favorable, since tenants are more motivated to renew because they are owners through the limited partnership. The leases should be structured using market rates because physicians eventually will retire and the building will have to go to the market for leases.

A Unique Perspective MOB development and redevelopment today should be approached from a unique perspective by the developers and physician owners, according to Lester Rich, former chief of staff at Encino-Tarzana Regional Medical Center in the Los Angeles area. Patients' needs come first — they are the ultimate end users, he says. Then come employee and staff demands, then physicians' needs. Recognizing the customers is likely to pay off for wise developers and owners in the long run.

Todd Hart

Todd Hart is chief operating officer of Flake & Kelley Management, a full-service real estate services provider in Little Rock, Ark. Contact him at (501) 375-3200 or thart@flake-kelley.com.

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