MOB Outbreak

The fast-spreading healthcare industry makes medical office buildings a lucrative investment.

A new trend in the growing healthcare sector offers physicians the opportunity for equity participation in new medical office building developments. Hospitals planning to build new MOBs on their campuses increasingly are turning to third-party developers and sponsors rather than constructing and owning the facilities themselves. As the business of healthcare changes, many physicians have become more-sophisticated business participants in joint medical ventures. MOB developers encourage this arrangement because physician-tenants who are offered MOB ownership are more likely to sign on early for projects and agree to longer lease terms.

As the prevalence of ambulatory surgery centers, or ASCs, specialty ancillary centers, specialty hospitals, and other evolving opportunities for physician-hospital joint venture participation has grown, physicians in certain U.S. markets have become accustomed to these additional earnings opportunities. Physicians familiar with investment options are more likely to push for equity participation in real estate. In particular, specialists such as those practicing cardiology, surgery, neurology, urology, and orthopedics, as well as larger physician groups, may find it easier to afford higher equity levels and can better tailor projects to their particular investment and diversification objectives.

Photo caption: Once-local hospitals now focus their resources on creating national healthcare facilities, such as Texas Children's Hospital in Houston, which has begun a $1.5 billion capital expansion.
Photo credit: Texas Children's Hospital

Developing MOBs

MOBs anchored by ASCs are becoming increasingly common because of the continued shift in the healthcare industry from inpatient to outpatient surgery. Also, physicians often find operating in an ASC environment more efficient, leading to a better experience for the patient and more income for the physician. A growing number of hospitals are happy to let developers and physicians divide MOB ownership so the hospital is free to concentrate their capital on core acute-care services.

But hospital executives often are concerned about losing the income stream if current surgical volume leaves the hospital and is transferred to an ASC. As a result, more hospitals are partnering with their physicians and a third party in operating two-party or three-party ASC joint ventures. Some hospitals favor physician investment in ASC ventures due to the belief that an ownership interest will encourage the physicians to make the ASC as successful as possible. Hospitals often want to have an ownership interest in these facilities, but they also want to outsource the non-core real estate development and ownership of the ASC. An attractive option is to offer physicians the ability to invest in both the ASC operations and the real estate.

In addition to ASCs, diagnostic imaging centers and other ancillary service operations also can be anchor tenants of MOB components. Again, hospitals often are more interested in owning and operating these building components than in being landlords for physician practice space. Joint venture structures and equity models have been developed to support the equity investment by physicians in these operations.

Equity Participation Models
Several models of physician ownership have developed to allow physicians to participate in MOB ownership as equity co-investors with the owner or developer of the project. In these models, physicians make passive financial investments and generally are not responsible for property operations. The ownership entity typically will be a limited liability company or a limited partnership, which allows the tenants to lease space and own an interest in the sponsor's ownership entity.

As the market has come to understand physician participation in MOB ownership, three different equity models have evolved to address those market needs.

Direct Cash Equity Contribution. In the most basic of the three equity participation models, physician investors make cash contributions to the project that typically are tied to the physician's proportion of building occupancy. The cash contributions can be made either in the planning stages or after construction is completed. In either case, participation usually will be structured so that physicians' risk is limited to the amount of their equity investments.

Physicians may obtain equity ownership pari passu with developers, meaning that a physician's ownership interest will have the same rights and privileges as the developer. When this is done prior to groundbreaking, physicians share all the risks and stand to gain all the rewards of the project's development on the same basis as the developer.

Oftentimes physicians do not want to bear the full risk inherent in the construction stage of a new project so the developer may assume the role of project guarantor based on the strength of the project's leasing profile. Developers assuming risk during the construction phase may structure their interest to achieve a higher return on the project. Any returns more than the amount of the developer's preferential return would be proportionately distributed to all equity participants based on their capital contributions and risk responsibility. Alternatively, a physician can obtain a post-construction ownership interest, which offers more-limited participation in the project with less risk.

Selling equity participation to physicians involves the developer issuing a private placement memorandum that outlines the terms of participation between the physician equity investor and the developer or sponsor offering the equity investment. The equity participation is offered pursuant to certain exemptions from registration under the Securities Act of 1933 and state securities laws. The memorandum spells out the investment criteria that have been developed for the particular project including a description of the securities offered, the eligible investor requirements, restrictions on transfer, the proposed purchase price, distribution provisions for participation in annual net cash flow, and proceeds upon sale or refinancing. Physicians considering an equity investment will want to get legal counsel and accounting advice as they consider the terms of any proposed offering.

Rent-Amortized Ownership. In this ownership model, the basic structure of the physician participation is similar to a direct equity ownership model; however, no initial equity investment is required by the physician. The equity required to establish the physician's equity position in the project will instead be contributed over the term of the physician's lease by paying an additional amount of rent sufficient to fund the equity contribution plus an amount to compensate for the sponsor's cost of equity contributed over time.

For example, assume that for every 2,000 square feet leased, a physician with a 10-year lease could contribute $10,000 toward an ownership unit under the direct cash equity contribution model. The developer could offer a comparable rent-amortized ownership structure to the physician as an alternative. Assuming that the sponsor's cost of money is 8 percent and the $10,000 was amortized over 10 years, then the tenant's rent would be increased by about $1,490 per year to reflect the sponsor providing the capital. The physician would participate in net cash flow and any proceeds for a sale or refinancing similar to the direct cash equity contribution model.

This ownership model requires careful analysis and consideration as the rents could be above market and lead to excessive leverage or result in a future buyer not factoring the higher rents into its underwriting upon a future sale.

No Equity Ownership. Colloquially known as the free equity model, in this alternative model physicians obtain participation in a portion of the project's annual cash flow and share of refinancing or distribution proceeds upon sale without making any equity contribution.

In one variation of the no equity ownership model, some developers may offer a fixed percentage of the building equity without any equity contributions to physicians who sign long-term leases by a particular cutoff date. In this variation, the developer is getting value from the early commitment of physician-tenants to long-term leases and returning some of that value to those physicians as equity participation. Longer-term leases - 10 years versus five years - for example, might enable the developer to give up 5 percent to 10 percent of the equity without impacting the developer's returns. The quicker lease-up period also improves the developer's returns and makes an equity position to physicians without contribution feasible.

Rendering caption: Cabrillo Medical Center, now being constructed adjacent to Children's Hospital San Diego, is a 31,711-square-foot, three-story class A office building that will be available for sale or lease to single or multitenant medical office users.
Rendering credit: Ware Macomb

Comparing Models

With the three ownership models, the ownership percentage offered by the sponsor will depend upon the amount of interest from prospective tenants. The direct cash equity contribution and rent-amortized ownership models may require a minimum contribution and the no equity ownership model may require a minimum level of subscription interest. The implementation of a free equity model is simpler than the rent-amortized or direct cash equity contribution approach because it does not require a private placement memorandum if the offering is not deemed to be a security.

All three options also require physicians potentially to be responsible for ongoing capital investments to improve the property during its operation, but the direct cash equity contribution model can be structured to limit that exposure.

The three models are illiquid investments, which may make it difficult for the physician to get equity returned in case of retirement, death, or ending a practice. Depending on circumstances, the direct cash equity contribution model may provide more liquidity than the other options through buy/sell provisions with the sponsor. The models also require close attention to legal and tax issues. The agreements required in the direct cash equity contribution model can be especially complex, although most sponsors are experienced at educating potential investors and already have established forms of offering memorandums and ownership documents.

One clear advantage that physicians get from a direct purchase/own building or condominium model is the ability to control the timing of the investment sale to meet their needs. The direct cash equity contribution model shares the characteristic of the direct purchase model in that physicians can participate in ongoing cash flow from the building operation, a feature that is not available with the condominium model. Additional benefits of the direct cash equity contribution model over the direct purchase/own model include operational efficiencies from a professional building manager, better ability to lock in operating costs, ability to structure the agreement to limit physician liability for post-occupancy costs if required, and potential greater flexibility to acquire additional space in the building if a practice requires expansion space.

Generally, physicians also appreciate that the direct cash equity contribution model is a purely financial investment. They do not have to worry about being a landlord or about building operational issues as is necessary in the other two models.

Physicians with excess funds may favor the direct cash equity contribution model, but for those with more modest means, the rent-amortized and no equity models are preferred. These models essentially are variations of the direct cash equity contribution model, so they have similar pros and cons. The rent-amortized ownership model can have an advantage of stronger property cash flows, which allow more aggressive debt financing terms. However, this introduces rent discrepancies between owners and non-owners, and it increases the risk of above-market rents due to amortized equity. Physicians can appreciate the benefit of a risk-free share of property cash flows and sale proceeds from the no equity ownership model.

Physician MOB ownership models will remain attractive as long as real estate returns are more lucrative than other alternatives such as stocks and bonds. Also, more sophisticated physicians and groups will realize that they can invest at the wholesale value level in new development projects to the extent that they sign long-term leases. By aligning the interests of physicians who can assure long-term stable tenancy with those of hospitals and developers who benefit from the stable cash flows that result from that structure, physician equity participation has become an increasing force in MOB development and ownership.


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