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Medical Office Holds Up in Troubling Times

Even as investors shy away from other property types, investment activity in medical office has held comparatively steady. For the first half of the year, transaction volume was at $3.18 billion, based on 482 transactions, according to Marcus & Millichap. In the first half of 2007, 521 transactions generated a volume of $3.4 billion. Brokerage Marcus & Millichap estimates that by year-end, sales volume will hit roughly $6 billion, compared with about $6.5 billion for 2007.

In addition, through the first half of 2008, capitalization rates on this property type have declined an average of 30 basis points to 7.1%, according to a report on the niche from Marcus & Millichap’s healthcare real estate group.

“It’s an expression of investors favoring the product, particularly at a time when general office has softened. Medical office has emerged as a product type where you will tend to keep your tenants longer,” says Alan Pontius, a San Francisco-based managing director of brokerage Marcus & Millichap.

The longer tenant tenure means a reduced turnover cost on required tenant improvements and leasing commissions. “That increased stability, the belief that the long-term supply and demand fundamentals are excellent — these factors combine to cause the perceived risk profile of medical office investing to be more favorable,” Pontius adds.

A long-term demand driver for the niche is an expected rise in the number of adults age 55 and over, a demographic that has traditionally required a higher level of medical attention than younger age groups. This group is projected to add 11 million to its numbers through 2012, leading to more demand for medical office space.

And as outpatient services continue to gain favor with more medical procedures being done away from hospitals, this adds impetus to demand for medical office space.

In anticipation of this upcoming demand, supply may have gotten a bit ahead of itself for the moment though. Marcus & Millichap expects that developers will add 17.5 million sq. ft. of medical office space nationwide this year, up from about 16 million sq. ft. for 2007. They are hiking up the pace of construction in anticipation of an increased future demand for medical office space.

“Right now, we are increasing the level of new construction at a much faster pace than we were in the earlier part of this decade,” says Pontius. “So rental growth in the sector, at least over the next 12 to 18 months, should be pretty moderate.” Nationally, Marcus & Millichap medical office projects asking to rise 1% to an average of $23.94 per sq. ft. in 2008.

Nationally, the vacancy rate for medical property stood at 11%, having gone up 0.6% in the first six months of the year. One region of concern is the Pacific Northwest region, where a heightened pace of construction activity has led to a jump of 1.10% in vacancy. Even then, the vacancy rate in the region remains on average a manageable 8.4%, and is also the lowest regional vacancy rate in the nation.

In the longer term, as vacancies rise modestly in the niche, construction lending will likely be curtailed, causing supply and demand for medical office space to get back into more of a balanced level.

One region in which developers have cut back on construction activity this year is the Southeast, largely on the impact of the housing market troubles. The region will gain 2.3 million sq. ft. of space in 2008, an 18% decline from the amount added in 2007. Considering that Florida is likely to remain a magnet for retirees, however, Pontius expects the pace to pick up in future.

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