Cover Story: Demand to continue well into 2015

While healthcare real estate executives have a few concerns, most seem to agree that the HRE sector continues to look strong 

By John B. Mugford

Java PrintingThe year 2014 in healthcare real estate (HRE) is likely to go down as the best in history, the culmination of a three-year run in which the annual volume for medical office building (MOB) sales rose to heights that perhaps seemed inconceivable a decade or so ago. But if you tend to agree with a group of experienced, well-known HRE professionals, then you might share their belief that this incredible streak will peak in 2015, perhaps 2016.

It’s not that 2015 will be a bad year. In fact, the HRE professionals consulted for this story believe the year ahead should mirror the record-setting 2014 in terms of MOB sales and demand from a wide range of investors, including large institutions, as well for development opportunities.
Yet these same professionals, members of the Healthcare Real Estate Insights™ Editorial Advisory Board, are also under the impression that the current state of historically high demand and near-historic high pricing will not, perhaps cannot, continue beyond the next year or so. A number of factors, such as increasing interest rates, improvements in other sectors, and, at some point, a possible shortfall of HRE properties, should bring about the end of an incredible run and usher in a more “normal” state for the sector.

As noted, 2014 finished with the highest MOB sales volume on record, about $8.33 billion, a 27 percent increase, according to statistics from real estate research firm Real Capital Analytics (RCA) Inc. RCA has tracked MOB sales since 2001, a time when the sector was considered to be in its infancy, and never has the sales volume approached that of 2014. (For more on last year’s MOB sales totals, please see “Another record year” on Page 14.)

The members of the HREI™ board gathered for our annual meeting last fall. In a meeting room on the campus of Scripps Memorial Hospital – La Jolla just outside of San Diego, board members, including host Ross Caulum, San Diego-based Scripps Health’s senior director of corporate real estate, spent a day discussing the current state of the sector, their strategies for remaining vital components of the sector, and the year ahead.

While most of the day’s discussion was “off the record” in order to promote a free-flowing exchange of ideas, board members were “on the record” when discussing their predictions for the next year.
2015 will probably look a lot like 2014 

Most of the board members said they believe that this year will be a good one for the HRE sector. They added that MOB sales, as well as sales of other types of healthcare facilities needed for patients along the continuum of care, should remain strong while new development opportunities are likely to continue to emerge.

“I think (2015) is going to look a lot like last year, which, when we look back upon it, will be about the peak of the healthcare real estate cycle,” said Jim Kornick, a managing director with the Washington, D.C., office of Avison Young.

Others agreed, including Greg Venn, president and CEO of healthcare development firm NexCore Group LP, based in Denver. But Mr. Venn added a caveat, saying that perhaps predicting a market peak in 2015, while it is likely, could also be premature.

“The interesting thing is that there just continues to be more and more capital coming into this sector, and that might counter the idea of a peak and could keep cap rates going lower despite a potential rise in interest rates,” he said.

“But for all practical purposes, it seems like the end of 2015 is when we should see the peak in values; but then again, who knows?”
Mr. Venn hinted at a potential hiccup on the horizon: a likely rise in interest rates, which could potentially damper pricing and slow sales. Board members said the sector could also be negatively impacted by an insufficient supply of product to satisfy investor demand, as well as improving yields on other investments.

However, some board members predicted that this will be another strong year for MOB sales for a number of reasons.

“I think we should all continue to fasten our seatbelts and hang on for the ride because it’s not even close to being over,” noted San Diego-based John Smelter, senior director of HRE for Marcus & Millichap.

“I think the demand for our product is going to hold steady well into 2015 and maybe 2016,” said Judson “Jud” Jacobs, senior VP of development for Dallas-based Caddis Partners LLC. “And that’s for both seniors housing and medical office, as the valuations will hold firm, short of some kind of shock to the system or if interest rates start rising more quickly than any of us anticipate. I think it’s going to be a great market that will continue to be a seller’s market for a while,” he added.

And who, during a time when supply cannot meet demand, will be offering MOBs for sale? As far as the board is concerned, it will continue to be development firms, private investors and equity sources that are being enticed to sell portions of their accumulated supply because of record record-breaking pricing.

Don’t expect to see many offerings from publicly traded and non-traded real estate investments trusts (REITs), board members said, because those entities typically hold assets for longer periods. Nor should would-be investors look to the nation’s health systems, which reportedly own an estimated 80 percent of all healthcare properties, as a potential source of large amounts of properties, they added. That’s because as health systems continue to add physicians to their employment rolls, they seem to be less interested in leasing space in MOBs.

But some professionals who provide services to health systems say that a growing number of them are at least considering the possibility of selling real estate assets, in most cases to help fund other capital expenditures that can produce bigger returns than real estate, to rid themselves of owning and having to manage real estate, and to take advantage of historically high pricing.

One of them is Philip J. “PJ” Camp, principal at New York-based advisory firm Hammond Hanlon Camp (H2C) LLC, noting that his firm is running more and more analyses of health systems’ real estate portfolios, with the potential for some sales, or monetizations, in the offing.

And Mr. Smelter of Marcus & Millichap notes that many private investors and institutions have exit strategies for their assets, meaning they could be sellers during this period of strong pricing.
“The REITs won’t sell, we all know that,” Mr. Smelter noted. “But you’re going to see most of the activity continue on the private side and on the institutional side that had those exit strategies put in place a long time ago when they raised their capital.

“I just don’t see a whole lot of change in 2015 because the demand is so high, our pent-up demand is so high even though we’ve been in a seller’s market for so long,” he continued. “Shy of interest rates going up in excess of 50 basis points, shy of something happening to our economy nationally or our worldwide economy, and unless we get into anything close to the financial crisis again, fasten your seat belt and hang on for the ride because it’s not even close to being over in my opinion.”
Medical office pricing likely to remain high

And where is pricing at heading into 2015? According to RCA, the average price per square foot (PSF) for MOBs has been hovering around $250 during the past year or so – about $25 above the sector’s peak years of 2006-08. Also, average capitalization (cap) rates, which estimate a first-year return on an investment, have been at or near historic lows of about 7 percent – an indication of high demand and pricing.

Pricing is so strong that Devereaux “Dev” Gregg, senior VP of development for Madison, Wis.-based ERDMAN, said: “If I owned a bunch of MOBs I’d be selling them right now.”

Darryl Freling, managing partner of Dallas-based MedProperties Group, which invests in a variety of healthcare projects and properties, noted that “because of the proliferation of healthcare real estate buyers, including many new buyers that keep coming into the marketplace, and as long as interest rates stay as low or nearly as low as they have been, this incredible demand is going to continue to drive pricing.” As Mr. Freling noted, if interest rates remain low, pricing could remain high – with cap rates staying low – for healthcare properties.

A number of board members said that while they do believe interest rates will increase – as the Federal Reserve Bank will have to raise them at some point in 2015. Even with a modest increase in rates, however, several board members said that cap rates would remain at or near the current rates of 7 percent or below if investor demand remains strong, which they believe it will.

“I’ve changed my opinion recently relative to interest rates and the thought that they would have to go up a fair amount sometime soon,” said Mark Toothacre, president of San Diego-based Pacific Medical Buildings.

“I think that central banks are having difficulty getting inflation up to even their target rates and the world economy is struggling, even though we’re doing okay here in the United State. So I think for the foreseeable future you’re going to see low interest rates, and consequently cap rates (for MOBs) will stay low.”

Jonathan L. “John” Winer, executive VP of White Plains, N.Y.-based Seavest Healthcare Properties, added that “a lot of institutional capital keeps coming into our market, which I think is having and will have an interesting effect. It will keep cap rates down or even maybe compress them a little bit more.”

Chris Bodnar, a senior VP and co-leader of the national Healthcare Capital Markets Group with CBRE Group (NYSE: CBG), said that he, too, does not foresee cap rates changing much in 2015, except, that is, for the highest quality, “core” facilities.

“The reason I say that is I think (2014) was the first year since we’ve been working in the space that the REITs have been priced out of core deals,” he said, “and that’s because of the institutions going after these types of products.”

Malcolm Sina, chairman of Sina Family Holdings and a long-time healthcare developer, said that he thinks cap rates will remain low in HRE as well as commercial real estate in general.

That’s because, he said, “if you look at the equity markets today, everybody feels that the equity markets have capped out. There’s not much more room for people to grow in the stock markets, and then secondary, everybody keeps saying that bonds, interest rates are going to go up – probably not that much next year.

“But with everyone saying that interest rates on bonds will go up, people are reluctant to put it into bonds. So where are they putting it? Into real estate, in large part because it’s a very easy product for people to understand that have historically been in stock markets and/or bonds.”
Change is creating new development opportunities

While there remains plenty of uncertainty about the future of healthcare in general, such as how health systems will continue to fare under the Patient Protection and Affordable Care (PPACA) and the changing environment, one thing remains certain, according to board members: consolidation will continue with more mergers of hospitals and health systems and the continued employment of independent doctors and group practices.

All of this consolidation and change has proven to be, so far, a catalyst for a fair amount of development opportunities for firms in the sector, according to board members.

Such opportunities should continue in the next year or so as health systems, in reaction to healthcare reform and other changes, look to grow and attract new patients by building facilities that can accommodate the latest in medical technology and house their newly hired and acquired physician groups.

“All of these mergers and acquisitions are creating interesting development opportunities that we would never have predicted just a couple of years ago,” noted Mr. Venn of NexCore. “We had been thinking that the elimination of some of our clients through consolidation would eliminate a number of opportunities. But the exact opposite is taking place. So in that regard, change is good.”
Deeni Taylor, executive VP of Indianapolis-based Duke Realty Corp. (NYSE: DRE), agreed with Mr. Venn, adding that he foresees even more mergers and acquisitions in the coming year.

“I think I think the number of healthcare consolidations is really going to take off, more than we’ve seen in the past,” Mr. Taylor noted. Perhaps as a result, and due to the changing strategies of health systems, he added that he believes the number of new, off-campus MOBs and other ambulatory projects “is going to exceed by a big margin what we’ll see in on-campus developments.” He expects to develop more single-tenant, multi-specialty facilities based on a clinic model. “The multi-tenant design just doesn’t work anymore,” he said.

Mr. Caulum of Scripps Health added that new MOBs are going to have to “be in retail locations,” “relevant to the customer” and affordable, forcing providers to be “hyper efficient.”

And what is built, he added, “is not going to be your father’s MOB anymore. It’s got to be open seven-to-seven, seven days a week, not eight-to-five, five days a week. And if that happens, just on number of hours, you’ve just doubled the throughput of that MOB by just number of hours.”

As the U.S economy continues to improve, “albeit slowly,” Mr. Jacobs of Caddis Partners said, he believes more and more healthcare systems will initiate projects.
“We’re already getting more inquiries and more calls from health systems that are looking at allocating some more of their capital to construction and improvement of their campuses, and as they grow in their marketplaces by replacing some of their outpatient centers,” he said. “So, I think all in all it should be a good year for healthcare development and real estate investment.”

Perhaps bolstering the prospects for new developments is the probability that constructions costs will not increase too dramatically in the coming year, ERDMAN’s Mr. Gregg said.

“At times, one of the biggest obstacles we face as a developer is how to build a new Class A building and deliver a rent that tenants can afford, because it’s so much a function of cost,” he said. “I was really pleased where construction costs were (in 2014), and I don’t see anything that says those costs will go up dramatically in 2015. I think costs will increase a little bit, but moderately.”

Matt Nurkin, director with Lend Lease Healthcare Development, believes healthcare in general is still in the midst of “a fundamental change; the model of the provision of care is going to continue to evolve.” As a result, he believes the design and the operational model for the facilities that need to be developed has to change and evolve to support this “new provision of care. I think there’s going to be a lot of uncertainty in the healthcare environment for some time to come, which I think it creates opportunity for our industry.”

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