Healthy Prescription?

Ringing up double-digit returns by taking advantage of lofty sale prices, seniors housing investors are coming off their best year ever. Leading up to the credit crunch that began to roil the debt markets in the summer of 2007, well-located, fully occupied assisted living buildings traded for more than $200,000 per unit. That's more than double the average sale price of $94,000 per unit for assisted living buildings in 2004.

But with occupancies showing signs of slippage at seniors-only buildings, a growing number of owners are diversifying into other property types. Medical office buildings appear to be just what the doctor ordered.

Sales of medical office properties nationally totaled some $5 billion for the 12-month period ended Sept. 30, 2007, up 29% from the same period a year earlier, reports real estate research firm Real Capital Analytics.

The growing demand for medical office properties in recent years has caused cap rates to plummet from about 9.5% to about 7%, putting the sector on par with conventional offices.

The average selling price for medical office hit $224 per sq. ft. in the third quarter of 2007, a jump from $120 a foot at the end of 2004.

Medical office buildings also share synergies with seniors housing, investors say. For starters, both property types are niche plays, and each is a part of the healthcare property continuum.

What's more, the two industries rely on the same demographics — a graying population that needs special housing and lots of medical services. New campuses are even blending the two property types, with medical facilities located adjacent to seniors housing projects (see sidebar p. 70).

Also, medical office buildings generate private-pay rents that typically rise at regular intervals. In contrast, nursing homes rely on government reimbursements by the Medicare and Medicaid programs that set rent payments.

Niche grows more crowded

As medical office construction ticks up and seniors housing owners struggle to manage a property type outside their traditional comfort zone, the strategy can be risky. Seniors housing and medical office are “completely different animals, subject to different risks and cycles,” says Angela Mago, senior vice president and national manager at Cleveland-based KeyBank Real Estate Capital Healthcare Group. But, she emphasizes, investors want to diversify their holdings.

Though some seniors housing owners plunged into the medical office arena several years ago, market forces could help accelerate the trend. The economy is slowing, but spending on health care isn't. The nation's health care bill exceeded $2 trillion in 2006, and spending is expected to increase at a rate of about 7% a year.

Competition for quality medical office properties is keen as investors of all types flock to the sector, traditionally viewed as a safe haven in troubled times. A burgeoning supply of medical office buildings has saturated some high-growth markets.

In Phoenix, for example, about 870,000 sq. ft. of medical office space is under development — or a 9% increase in total market supply, reports brokerage Marcus & Millichap Real Estate Investment Services.

About 1.5 million sq. ft. of medical office space in the Miami/Ft. Lauderdale area was added in 2007. Another 1 million sq. ft. will open there this year. In Las Vegas, the medical office vacancy rate hit 16% in 2007. Orange County, Calif., experienced three quarters of negative net absorption last year.

“In the short term, there may be some hiccups as these markets work through the space coming online,” notes Yitzie Sommer, senior manager of research for the national office and industrial properties group in the Chicago office of Marcus & Millichap.

Rapidly growing markets have a history of absorbing medical office space quickly, but industry observers say that may not be the case this time around. A possible economic recession could slow the pace of medical office leasing.

During soft economic patches, people are less inclined to visit the doctor. Meanwhile, construction costs have risen so high that many primary physicians can't afford to lease or buy into a new building, which could raise vacancies. “That's a concern,” acknowledges Mago at KeyBank.

Important distinctions

Investors need to be aware that unlike seniors housing, which is a service-oriented business geared toward residents, medical offices must cater to the special needs of doctors and hospitals.

Medical office exhibits a different risk profile than seniors housing, says Jonathan Winer, principal at Ernst & Young in New York. Many seniors housing investors hire a management firm that takes the operating risk. Medical office buildings are typically owner operated, making it a hands-on business.

The Plaza Cos. of Peoria, Ariz. owns and operates about 6 million sq. ft. of medical office and seniors housing properties. “Seniors housing and medical office are like night and day,” says Sharon Harper, president and CEO at the Plaza Cos. “They have common denominators, but each requires a distinct operating style,” according to Harper.

Plaza has separate divisions for seniors housing and medical office properties. “There are major pitfalls with both,” notes Harper. Medical developments require knowledge of physician networks and hospitals, plus knowledge of how physician practices invest in buildings. Investors also need to understand the tenant improvements required by physicians, such as special plumbing.

In contrast, seniors housing operations are totally focused on the residents and their needs, Harper says, adding that seniors housing is not like multifamily properties or hotels. “It takes real sophistication to do [seniors housing and medical office] well.”

An operating partner is key, according to broker Michael Berne at Cushman & Wakefield in New York. He recalls the late 1990s when lots of developers went into seniors housing and overbuilt assisted living facilities, assuming it was a pure real estate play. That may have been a blessing in disguise, according to Berne. “I think folks have learned their lessons.”

Joining the gold rush

The big seniors housing REITs are pushing into medical office to the tune of about $4 billion in the last two years. Private investors are joining the drive, too. Servant Healthcare Investments, a newly formed equity firm in Orlando, focuses on both seniors housing and medical office buildings. Companies that own both enjoy an investment premium, according to John Mark Ramsey, Servant CEO.

Ramsey was formerly an executive at CNL, a senior housing REIT purchased in 2006 for $5.3 billion by Health Care Property Investors. Before its purchase, CNL's strategy was to own both seniors housing and medical office properties. “We got a premium for that portfolio because of the mix of properties,” says Ramsey, who estimates the premium ranged between 10% and 12%. Likewise, he expects the Servant portfolio to fetch top dollar at sale time.

The decision by seniors housing companies to diversify their holdings has led to some mega deals. In 2006, Health Care REIT purchased Windrose Medical Properties Trust, a deal valued at $924 million that included 92 buildings. Last spring, Health Care REIT acquired 17 medical office buildings developed by the Rendina Cos., along with Paramount Real Estate Services, a medical property management firm, for $288 million.

The acquisitions increased the percentage of the portfolio that generates private-pay revenues to 65%, according to Ray Braun, president at Health Care REIT based in Toledo, Ohio. Private-pay revenues are considered less risky than relying on government reimbursement programs such as Medicaid and Medicare. These programs that fund much of nursing home care are subject to lawmaker approval, making it difficult to predict rents going forward.

The healthcare REITs are drawn to medical office buildings for another reason, according to Winer at Ernst & Young. “It's a growth opportunity, and REITs need to grow.”

U.S. healthcare expenditures by 2016 are expected to double to $4.1 trillion, according to a report by the National Statistics Group at the Centers for Medicare & Medicaid Services.

The highest proportion of healthcare spending is for older adults, the same target demographic of seniors housing. By 2020, the number of people ages 65 to 74 is projected to increase from 6% to 10% of the nation's population. Those persons ages 75 and older are expected to account for 6% to 7% of the population, according to the U.S. Census Bureau.

Market synergies

Ventas Healthcare Properties Inc., a seniors housing owner based in Louisville, Ky., is increasing its medical office holdings from 1% to at least 10% of its portfolio, says Vince M. Cozzi, managing director at the Ventas office in Chicago. “Medical office and senior housing go together as an investment,” he says.

Medical office is a smart way to capture baby boomers who are driving demand for medical services, according to Cozzi. Ventas had been focused on skilled nursing facilities and long-term acute care hospitals. “We want to be closer to the front end of the boomer's cohort. Medical office is a continuation of that strategy,” says Cozzi.

Eventually the boomers will be in need of long-term care in seniors housing facilities, adds Cozzi. “As boomers age they will be moving through the kinds of real estate we own.”

Like other investors seeking safe returns, Ventas prefers medical office buildings located on a hospital campus or in a building affiliated with a hospital. These properties draw tenants because of the hospital link and tend to be less risky than one-off medical complexes.

Medical office properties generate annual yields of approximately 7% compared with 8% for seniors housing properties, Cozzi says. “We're not looking at one over the other because of the return,” he states. “We are looking to diversify.”

While it's uncertain whether sale prices will remain strong in an economic downturn, a scarcity of quality medical office properties could keep prices high for Class-A projects, say industry experts.

Seniors housing properties have been on a tear, too. Investors have been flocking to the sector, with a series of blockbuster deals over the last two years. And despite the credit market woes, on Dec. 21, private equity firm The Carlyle Group closed its $4.9 billion purchase of nursing home owner Manor Care.

Effect of housing woes

The current housing slump has only enhanced the attractiveness of medical office properties. Occupancies at rental buildings for independent seniors dropped by about 1.3% over the second and third quarters of 2007, according to the National Investment Center for Seniors Housing based in Annapolis, Md. Vacancies could rise further. Seniors generally do not move into a rental building until they sell their houses, and the for-sale housing market is depressed.

Last year, Healthcare Realty Trust sold its entire seniors housing portfolio for $400 million in order to focus only on medical office properties. In a statement, the Nashville-based company said medical office would carry a lower risk profile than seniors housing, and also create more development opportunities.

Medical office is perceived as a safe harbor of sorts for many investors. Physicians tend to be stable, long-term tenants. Lease terms for physicians average about nine years, compared with about four years for general office tenants, says John Smelter, senior director of the healthcare real estate group at Marcus & Millichap in San Diego.

As Winer of Ernst & Young notes, “Medical office has proven to be more recession-proof and less subject to economic changes than conventional offices.”

The prospect of higher returns may have initially attracted investors to medical office, but their stable performance is what keeps this asset class in demand.

Jane Adler is a Chicago-based writer.


Seniors housing REITs continue to diversify into medical office, lowering their exposure to the depressed housing market. In the past two years, REITs have plowed $4 billion into the niche.

Buyer Acquisition Target Deal Value Closing Date
Health Care REIT Windrose Medical Properties Trust $924 million Dec. 20, 2006
Health Care Property Investors Slough Estates USA $3 billion Aug. 2, 2007
Nationwide Health Properties Multiple buildings $56 million Third-quarter 2007
Source: Company reports

Why the medical campus is gaining momentum

Seniors housing has become a popular addition to college campuses. But now another type of campus is gaining favor as a site for seniors housing — the medical campus.

The idea makes sense because older people visit the doctor more frequently than younger people, experts say. Older people are naturally more concerned about where they live in relation to medical services, too.

The Plaza Cos. of Peoria, Ariz. is a pioneer in the field. In 1982, it built one of the first medical campuses, Plaza del Rio, a 180-acre project in Phoenix that includes 400,000 sq. ft. of medical office space and 1 million sq. ft. of seniors housing.

The seniors housing portion of the development features rental apartments, three assisted living buildings, two skilled nursing facilities and a continuing-care community. The local hospital added a home for the impaired children of seniors, and an in-patient overnight stay hospice facility.

Demand is strong for a high-quality combination seniors housing and medical development, says Sharon Harper, president and CEO at the Plaza Cos. “We plan to do more of these communities.”

In North Scottsdale, the Plaza Cos. and Classic Residence by Hyatt have teamed up to develop a new continuing care community, Classic Residence by Hyatt at Silverstone. The project is part of amaster-planned development that also features upscale homes, luxury retail space and medical facilities. The Hyatt project features 270 independent-living apartments, along with assisted care, skilled nursing and memory care units.

In Middletown, Ohio, a health campus is taking shape that combines seniors housing and medical services. The 190-acre site includes the Atrium Medical Center. It opened last December. The campus features a medical office building, cancer center, behavioral health pavilion, surgery unit and pediatric care center.

Avalon by Otterbein, the seniors housing facility on campus, is slated to open later this year. It features five homes with 10 residents per house, fashioned after the well-known Green House program. It was first developed by Dr. William Thomas, a pioneer in humanizing nursing homes.

The Avalon houses will be built on a cul-de-sac. Each resident will have a private room. Residents share common living areas and a kitchen.

“This is a very residential nursing home,” says Rosemary Cicak at Otterbein Homes Inc. in Lebanon, Ohio. “But residents will also have easy access to a state-of-the-art medical facility.”
— Jane Adler

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