Medical Office Buildings: Remedy for an Ailing Market

Developers and investors are discovering that health care real estate may be just what the doctor ordered for a slumping real estate market. The demand for healthcare real estate — namely medical office buildings — has remained strong despite skyrocketing vacancies in the national office market.

Occupancy rates for medical office space top 90%, sources say, thanks in part to long-term leases and minimal turnover among physician tenants. In contrast, the traditional office market has struggled with a vacancy rate of about 16.6% nationally for the past year, reports CB Richard Ellis.

“In the last two years, the healthcare real estate niche has become red hot,” says Bob Rosenthal, president of San Diego-based Pacific Medical Buildings. Rosenthal will serve on a panel discussion on “Development and Investment Opportunities in Health Care Real Estate” at the annual National Association of Industrial and Office Properties (NAIOP) conference Oct. 19-22 in San Diego.

Health care real estate represents a relatively small segment of the commercial real estate market — an estimated 5%, according to industry experts. However, this real estate niche is benefiting from a burgeoning health care industry. U.S. health care spending totaled $1.54 trillion in 2002, and is expected to more than double to $3.1 trillion by 2012, according to the Center for Medicare & Medicaid Services.

That growth coupled with stable returns has piqued investor interest. The health care real estate panel, which will be held Oct. 21, will provide an overview on trends affecting medical office buildings. In addition, panelists will offer insights on how medical office space differs from typical commercial space in terms of design, construction, financing and property management.

Barriers to Entry

Medical office space is not an easy niche to break into. “Financially, they are good deals. But for a general office developer to think this is just another type of office building, you would be making a mistake because these buildings are very difficult to manage,” Rosenthal says. Physician tenants typically require more hand holding, he says, and there are greater maintenance and upkeep issues due to the high volume of patient traffic.

One way for newcomers to enter the health care market is via joint ventures with an established developer or owner. For example, Health Care Property Investors Inc. (HCPI) formed a joint venture with GE Commercial Finance last fall with the $575 million purchase of MedCap Properties, which included its portfolio of 113 medical office buildings.

Medical office buildings also are more costly to build. The shell construction is much the same as traditional office development. However, the interior buildout is more costly due to unique design requirements. For example, medical office buildings require elaborate HVAC systems, radiation shields and sound control. The build-out on medical office space runs about $80 to $100 per sq. ft. compared with $25 to $35 per sq. ft. for traditional office space.

Buying health care real estate isn't cheap, either. “It has become a very competitive market,” notes Chuck Elcan, executive vice president of medical office properties for HCPI, a Long Beach, Calif.-based REIT. Elcan also will serve on the NAIOP panel.

“The incredible demand is driving prices up and cap rates way down,” agrees Rosenthal. Last October, Pacific Medical paid $128 million for a portfolio of 22 medical office buildings from Catholic Healthcare West at a cap rate of 8.65%. Pacific has an offer on the table for one of those same buildings for a cap rate of 6%.

Long-Term Play

Medical office buildings have sparked the interest of developers in the last few years due to depressed office and industrial markets. However, the sector also has tremendous long-term potential because of the growing demand for medical office space.

The aging population of baby boomers is one factor. The number of Americans age 65 and older is projected to double to 71 million by 2030, accounting for nearly 20% of the total U.S. population. At the same time, new hospitals and medical facilities are following population growth or shifts in certain parts of the country.

“Commercial real estate follows rooftops, and it is the same in health care real estate,” says Murray Wolf, publisher of the newsletter “Healthcare Real Estate Insights,” who will serve as panel moderator. “Once people get a taste of this market, they realize that it is not a short-term play, but that it will be strong for years to come.”

At A Glance

WHAT: NAIOP Annual Conference

WHERE: San Diego Marriott Hotel & Marina in San Diego, Calif.

WHEN: Oct. 19-22

WHO: Approximately 1,000 developers, owners, investors and other real estate executives are expected to attend.

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