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