Boomers, Health Care Reform Bode Well for Medical Office

Despite debate over proposed overhaul to U.S. health care system, fledgling sector is positioned for continued growth.

The national drama playing out over health care could have profound implications for medical office by providing coverage to some 46 million uninsured Americans, thereby increasing the demand for space. The politically charged debate includes proposals for a public plan, a mandate that most U.S. citizens buy health insurance, a federal exchange where individuals and small businesses could buy insurance and tax credits to help pay for the plans.

The debate has driven many health care professionals to the sidelines with respect to their real estate decisions. Regardless of the outcome, the burgeoning health care sector is already enjoying a surge in investment activity as a result of the aging population of Baby Boomers. If Congress approves President Obama's sweeping overhaul of the nation's health care system, the medical office sector could receive an even bigger boost.

“The overriding goal of health care reform is to expand access, quality and affordability,” says Al Pontius, national director of Marcus & Millichap's office and industrial properties group in San Francisco. “Consequently, you're going to see very solid demand characteristics for medical office buildings over the longer term, and in particular related to health care reform.”

Drivers in place

Already, a major health care overhaul is under way. The American Recovery and Reinvestment Act of 2009 includes an allocation for prevention and wellness intervention that places a stronger focus on primary care physicians.

An estimated 8,000 additional primary care doctors will be needed to care for the newly insured that result from the reform, according to Marcus & Millichap. Just half of these new doctors would generate an additional 7 million sq. ft. of demand for medical office space.

Currently, Baby Boomers account for 29% of all uninsured Americans. If reform increased health care insurance coverage for 95% of all Boomers, doctor's visits would also rise by 34 million each year, reports Marcus & Millichap, which tracks medical office buildings used by physicians and laboratories such as surgery centers and outpatient facilities.

Pontius cites a prime example of the impact of health care reform on commercial real estate. Massachusetts' version of universal health care reform, enacted in 2006, resulted in 97% health care coverage of the state's population. Over the past three years, the increased demand has translated into a 14% increase in the state's medical office inventory, or 1.8 million sq. ft. of new space.

Investors also have responded positively to the reform. Last year, the dollar volume of medical office transactions in Massachusetts rose 55%. With the state's budget shortfall, however, Massachusetts is struggling to pay for the program.

Fundamentally sound

Property fundamentals for the medical office sector are already on a firm footing. “Out of all the niches, medical office has the lowest amount of distress at only 1%, or nearly $200 million, which is nothing compared with the $18 billion in the traditional office sector,” explains Jessica Ruderman, senior analyst with New York-based research firm Real Capital Analytics. The research firm defines distressed properties as those that are in foreclosure or bankruptcy, or for which the loan is being restructured.

Nationally, medical office transactions of $5 million or more are on the rise. For the first half of 2009, medical office sales accounted for 8.4% of all office transactions, compared with 7.6% in the same period last year.

Although the economy has caused office vacancy rates to spike across the board, the injury to medical office appears much less severe. The vacancy rate for medical office is projected to end the year at 12.4%, up 100 basis points from a year earlier, while general office vacancies are expected to breach 17%.

Despite the rosy prognosis, the medical office sector isn't immune to risk. Brandon Wallace, a broker in the Atlanta office of CB Richard Ellis, says many physician practices are staying in their current space and extending lease terms versus testing the waters in a new market.

“Because of some uncertainty over what health care reform is going to look like coupled with the overall economy, many physicians are pulling back the reins,” says Wallace.

In addition, new space continues to hit the market. “We have been adding medical office space aggressively to the national inventory now for the past several years,” notes Pontius. More than 17 million sq. ft. of new space came to market last year and another 14.1 million sq. ft. is slated for completion in 2009.

“There are some markets like Phoenix and Las Vegas that are clearly overbuilt today for the current level of demand,” says Pontius. Nearly one-third of the new inventory last year was built in the Southwest, where housing boomed and healthy population growth bolstered demand. Now cash-strapped consumers have cut back on elective services.

But perhaps the most distinguishing characteristic of the medical office sector is strong valuations. At midyear, medical office space fetched an average of $251 per sq. ft., up from $218 per sq. ft. in mid-2008, a 15% jump. “If you're looking for a safe asset that you want to hold long term,” says Ruderman, “I would say buy medical office.”

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