A provider, developer, investor, broker and architect shared their views during the recent Urban Land Institute Spring Meeting in Nashville, Tenn.
By Murray W. Wolf
A healthcare real estate (HRE) panel discussion at a recent Urban Land Institute (ULI) meeting provided newcomers to the space with a blunt assessment of the risks and rewards associated with the HRE sector – prompting the publisher of Healthcare Real Estate Insights to later joke with the panelists that they had probably cost the magazine some potential subscribers.
Did panel’s candid views on the state of the healthcare business actually scare off some would-be industry entrants? We’ll probably never know. But it can be said with certainty that the panel provided a valuable, clear-eyed assessment of this attractive but challenging business for HRE veterans and neophytes alike.
The panel, titled “Health Care Real Estate: Demystifying This Growing Sector,” was held April 17 during the ULI Spring Meeting in Nashville, Tenn. The panelists were:
■ Catherine “Cathy” Demmitt, director facility management for Indianapolis-based BSA LifeStructures;
■ Erwin Effler III, VP of real estate development for Minneapolis-based Ryan Companies US Inc.;
■ John Milne, M.D., senior VP, real estate and construction for Renton, Wash,-based Providence St. Joseph Health; and
■ Jonathan “John” Winer, senior managing director and chief investment officer for Seavest Healthcare Properties LLC of White Plains, N.Y.
The moderator was Mary Beth Kuzmanovich, the Charlotte, N.C.-based national director healthcare services for Toronto-based Colliers International (NYSE: CIGI).
HRE: A $1 trillion market
Ms. Kuzmanovich kicked off the discussion with an overview of the HRE market to “make sure we have a common framework around what’s happening in the healthcare real estate sector.” Citing data from the HRE research firm Revista, she noted that the total value of the market as of Dec. 31, 2017, was $1.12 trillion. That included both hospitals and other inpatient facilities (5,522 properties valued at $640 billion), as well as medical office buildings (MOBs) and other outpatient facilities (32,158 properties valued at $372 billion).
“Big money,” she noted. “If you compare it nationally, that’s about the same size as the multifamily sector.”
Most of the investment opportunities are in MOBs, Ms. Kuzmanovich continued, “and when you look at the ownership within the (MOB) sector,” it turns out that 51 percent of those MOBs are owned by hospitals and health systems.
“Some of them do trade… but a lot of those health systems own and retain ownership of those assets,” she said.
According to Revista, the other owners of MOBs are private investors (19 percent); providers (such as physician practice groups, 14 percent); real estate investment trusts (REITs, 11 percent); and the government; primarily the U.S. Dept. of Veterans Affairs (VA), and other (5 percent)
“You’ll also hear within healthcare real estate about being on campus and off campus,” Ms. Kuzmanovich continued. Historically, she said, most healthcare campuses have been centered around an inpatient hospital. So most investors have preferred on-campus MOBs because of their strategic relationship with the adjacent hospitals and the synergistic movement of patients between inpatient and outpatient spaces.
“However, one of the trends that we see,” she said, is that hospitals and health systems are pushing their services out into suburban areas. “So those off-campus assets are starting to become equally attractive, in many cases, from an investment and a service perspective.”
Despite the growing popularity of the MOB space among investors in recent years, Ms. Kuzmanovich pointed out that the fundamentals of the product type have weakened slightly during the past few quarters. Occupancy rates, revenue growth and net operating income (NOI) growth have all declined since early to mid-2017, according to Revista.
“And you know this from what you read in the newspaper and some of what you see happening coming in and out of Washington D.C.,” she said, that hospitals and health systems are under pressure to reduce costs.
“They’re looking to lower their operating expenses, which is pushing down some of that revenue growth and having an impact we’re starting to see on NOI growth.”
At the same time, the dollar volume of MOBs sales declined last year to about $11.9 billion from a high of $15.8 billion in 2017.
“And the buyer landscape is changing as well,” she said. Private investors accounted for 61 percent of MOB sales volume in 2018, compared with 32 percent the previous year. The healthcare REITs, which had been the largest investor group in 2017 at 40 percent, dropped to 14 percent last year. Most blame the decline in REIT investment activity on rising interest rates last year, which negatively affected REIT share prices.
Ms. Kuzmanovich noted that spread between the capitalization rates (the anticipated annual rates of return) for on- and off-campus MOBs had narrowed steadily over the years, but the spread has widened during the past few years. In addition, after hitting lows toward the end of 2017, MOB cap rates have increased during the past year or so. The 12-month rolling average for on-campus MOB cap rates was 6.7 at the end of last year and 6.1 for off-campus MOBs.
“We’re starting to see a little bit of a divergence” in on- and off-campus cap rates, she said, because some hospitals and health systems are using off-campus locations as more of a short-term “test” as opposed to a long-term commitment. That makes those off-campus assets potentially more risky for investors, which necessitates a greater return.
But to better understand the HRE space, Ms. Kuzmanovich concluded, “you really need to understand the healthcare industry itself.” So with that she invited Dr. Milne to share his insights.
Understanding the healthcare industry
“If we backed up 100-150 years,” Dr. Milne began, “you think about the trend of the 19th century into the 20th century, what was the state of healthcare?” He noted that hospitals came of age and became the hubs of healthcare delivery, but care remained rather basic.
“There wasn’t really a lot of technology being brought to bear,” Dr. Milne noted. But during the 20th century and into the 21st century, he said, “We’ve really had an exponential growth in technology, just like many other parts of the economy, other parts of society.”
However, he noted that our payment system hasn’t evolved as rapidly as our care system. He explained that most healthcare is still reimbursed on a fee-for-service basis.
“I do something for a patient or provide a specific service and I get paid for it. And that’s the way healthcare has been for most of the history of the United States,” he said. “The trick for us, though, is that we’ve got downward pressure for us as an industry on our topline revenue.”
Noting that much of healthcare spending is provided by the federal government in the form of Medicare, he said, “we continuously have downward pressure for the services we provide.” Private health insurance companies are also pushing for lower costs.
“So it’s an interesting economic model in the sense that you and I – if you’re the patient and you come to me as a physician and ask for a service – you really don’t care what the cost is or what the service is (and) I really don’t know what I’m charging for it because there’s a third-party contract and a third-party piece to this economic model…”
“That economic model, though, is getting disrupted,” Dr. Milne said “And so what we’re getting into for all of us in the healthcare sector is much more what we call a fee-for-value service.
“And we’re looking at a population health,” he continued, referring to the concept of actively managing the health of a larger group rather than a single patient. “How do I actually deliver health as opposed to delivering healthcare? And it’s a subtle difference, but it’s about how do we keep people well? How do we keep people healthy?
“And the insurance models are starting to pivot and change as consumers are becoming more active in the market,” he said, citing the examples of high-deductible health insurance plans and healthcare savings accounts (HSAs).
“The percentage of people who have those is radically changing the way we behave within the market,” he said. “People are becoming consumers” who are paying much closer attention to the cost of their care.
At the same time, inpatient hospitals used to be where most healthcare was delivered, he said. But that is no longer the most cost-effective way to deliver care. The construction costs for new hospitals, particularly in the Southern California market, can approach $1,500 per square foot, he said.
“So it is a significant amount of investment to try to put hospital infrastructure in place,” Dr. Milne continued. “As a result, health systems are moving toward integrated health delivery networks that include a continuum of community-based care, acute care and post-acute care.
“And so from a real estate perspective, the care model is not just the hospital anymore, and it’s not just the office buildings where the physicians have their space,” he said. “It really becomes the broader continuum of care, whether it’s a wellness center, a fitness center, the digital platforms that we use as we look at technology-enabled telemedicine types of services…”
So the key is to think about medical real estate within the construct of population health, he said, including how to leverage technology and more convenient locations.
“And so where Mary Beth was talking about the migration from on campus to off campus, that’s the trend you’re seeing in medical office. What I’d also say is there’s also the trend of moving from that MOB into a retail center” and into mixed-use developments, Dr. Milne said. “There’s also that piece that’s moving from a retail environment into a home-based, technology-enabled care platform.”
In addition, when providers engage with employers, they are looking at things like embedding clinics into corporate campuses, as well as other commercial office space.
“We’re partnering with the employers that we work with to be able to understand what types of commercial office space are there,” he said. “ We also have several projects across our system where we are an anchor tenant in a larger mixed-use development and are partnering with the developer to think about what does wellness look like, what does health look like, for that community?
“And our definition of what we look at as far as real estate and what it means to be engaged with health and real estate is much broader than it ever has been in the past,” he said. “And so as we move from being a hospital-based to hospital-focused company… it becomes a much broader platform as we look at it. And I would encourage all of you as you’re thinking about development in all of these sectors to be thinking about health and wellness” and how to integrate a health system partner into those delivery access points across a community.
HRE’s ‘overnight’ transformation
Ms. Kuzmanovich then asked Mr. Winer of Seavest about some of the unique challenges posed by the HRE space.
“What’s your investor appetite? What’s your investor anxiety about the medical office and healthcare real estate sector?” she asked.
“Well I think the business has changed considerably” from 10-15 years ago when the investment focus was on on-campus MOBs, Mr. Winer replied. “That was really the gold standard. That’s what everybody wanted to own.
“And it was just the simple theory that these are key strategic assets for a healthcare system and therefore they were never leaving, and all their voluntary doctors – doctors who practice at the hospital but are not employed by the hospital – that’s where they want to be,” he said. “And for a long time that was the game plan – not really that complex.
“And then… health systems really started to want to push off the campus, unpack the campus, get out into the community, make it convenient to the patients, convenient to their staff – quite frankly, a more user-friendly experience. And the whole nature of healthcare changed, and hopefully from a system’s perspective, it was a lower-cost way to delivery healthcare also.
“When this happened, though, all of the sudden everybody who grew up kind of saying, ‘On campus. It’s so easy. We’ve got the game plan’ – you had to change. Because the nature of the asset once you go off campus, the quality of the asset, the strategic purpose of the asset, the location, the re-lease potential, all become much bigger factors,” Mr. Winer continued.
“And so overnight the industry was transformed from one of a relatively simple investment formula to an industry that really had to understand healthcare at a very strategic level, to understand the quality of the assets that they’re investing in.
“And so when you talk about… what keeps you up at night, what gives you anxiety… from our standpoint it’s making sure that we’re investing in ‘forever assets’ – that we’re a long-term holder of our assets, whether we’re developing them with our development partners, or we’re buying them directly. But we’re looking to invest in assets that are key, critical assets, now and for the foreseeable future for healthcare systems,” Mr. Winer said.
“And it’s not always obvious. And we can talk about some of the reasons why it’s not always obvious. But I’ll just stop here for a moment and say it’s not always obvious and it’s made our business a lot more difficult, challenging.”
Why work with a developer?
Next, Ms. Kuzmanovich asked Mr. Effler why providers sometimes work with third-party developer like Ryan Companies.
“A lot of reasons,” he replied. Although some health systems tend to “self-develop” (manage their own development process without outside help), “a lot of them, especially mid-sized health systems that don’t have a real estate staff, need that help. They need help with somebody identifying a market, looking at different sites, putting together an operational pro forma, putting together a business plan for studying the volumes, understanding some of the restrictions that could be in a shopping center. They need a partner, somebody to guide them through all this.
“And, oftentimes, they also need someone to help them to look at a building and not over-invest in it,” he said, sharing a recent example of an administrative office redevelopment project for a health system for which the client initially asked for the same level of building infrastructure needed for impatient space.
“And we said, ‘Guys, you don’t need any of this stuff. The cost is coming through the roof.’ So we were able to use our comps because we also do office buildings and other sectors as well,” he said, to “provide those benchmarks to guide them making those decisions, especially in the off-campus environment.”
What are some design trends?
Ms. Kuzmanovich then asked Ms. Demmitt what she, as an architect, is seeing from a design perspective – not only in terms of a push off campus, but also into a more integrated model.
“So we’re seeing a lot of that,” Ms. Demmitt replied. “We’re actually doing a lot more with developers – a lot more than we’ve been doing with developers in the past – because they’re partnering with the architects, the healthcare system and sometimes the program manager to look at the demographics to find what the best place is.
“It’ll always be ‘location, location, location,’ ” she said. But she said that focus on location causes problems for a lot of healthcare systems, “especially in the high-entitlement states (where) there’s so much land cost. They have to put that in the pro forma.
“So we really are seeing a shift to the communities, specifically your non-CON (certificate of need) states. You’re actually going out to the people. People don’t want to drive 30 minutes.
“And part of what of what’s changing, is that in the past, the surgeons want to be next to the hospital. But now you’ve got hospitalists instead of physicians in the hospitals. So a lot of times the doctors don’t ever have to go to the hospitals. They can actually see their patients in the outpatient setting,” she said.
“So we’re seeing a lot of development with outpatient, and they don’t call them MOBs from the healthcare perspective because they’re not just an office building. You’re pushing oncology and surgical services and infusion therapies for rheumatism. These are hospital procedures that are now being pushed into the outpatient setting.
“And so you have to pay attention to those requirements and they make the building a little more complex. It’s good to have a partner that understands that going into it,” Ms. Demmitt continued.
“The other thing we’re seeing with the downfall of retail and the minimization of retail – there are a lot of empty boxes out there,” she said. Some retail mall owners are seeking out healthcare facilities, such as surgery centers, as anchor tenants. That allows a family to eat, shop, and sometimes enjoy outdoor walking paths and other amenities while they wait for a loved on to have a procedure done.
Retail sites: ‘Patients love it’
Ms. Kuzmanovich then asked Dr. Milne where Providence St. Joseph Health stands with regard to moving services to off-campus locations.
Dr. Milne replied that Providence recently did a study of its 51 hospitals and determined that 50 percent to 60 percent of its volume can be migrated off-campus during the next 10 years, “depending on what market we’re in.”
For example, he said, if you think about the services a hospital provides for surgery, the same could potentially be done with an ambulatory surgery center (ASC) and a hotel. Add an urgent care center and some medical office space, he said, and “I’ve basically got a hospital… because I’ve got places to ward people, I’ve got places to do surgery, I’ve got places for people to come when they’re urgently sick, and I’ve got some kind of office space for the doctors… A lot of that to a large degree can, in the right circumstances, be done outside of what we traditionally think of hospital-grade construction.
“And so we’re going through on a service line-by-service line basis and we look at how those services can be provided outside of that,” he said. Considerations regarding whether to shift a service off-campus include technology, risk and customer demand.
“Customers are saying, ‘I don’t want to come to the big mega (medical) center… I want to be able to get these services done where we’re at.’
“You mentioned big box (retail sites),” he continued. “We have a couple of those in our systems that we’ve redeveloped, citing a former home improvement retail space that was repurposed for use as a multispecialty clinic.
“Patients love it,” he said. “They love the access point. It’s sitting in a strip mall.”
Dr. Milne said Providence is also “doing a lot of small retail access points that are telemedicine enabled, in terms of being able to bring specialists on demand when we need it…” He said a range of factors are considered “and it’s different community by community.”
What’s driving change?
An audience member asked the panelists what is driving the change in the healthcare industry and HRE space.
“I think a lot of the activity you’ve seen is based on trying to drive the cost out of healthcare,” Mr. Winer replied, “and I’ll leave it to John (Milne) and others to comment on quality of healthcare related to these facilities. But a major drive of this whole ambulatory outpatient trend is cost.
“From the quality perspective I would say quality are table stakes to a large degree,” Dr. Milne said. “We have to assume that we can provide the quality of care that we want to provide in whatever location we choose to do it.” So what providers are trying to do, he said, is to maintain quality while driving down costs.
“I would say 100 percent is being driven by economics,” he said.
“It’s also being driven, though, by consumer demand. We live in an Internet-based society. Amazon delivers in two days… Everything has narrowed… Our lives are radically different than they were in the 1950s when many of our hospitals were built. And so the location of where we have facilities just doesn’t match the demand for what consumers in the market are looking for. So that’s a big portion of what the driver is for us.”
In addition, Mr. Effler said, “It’s a little bit of follow the money, and there are a lot of perverse incentives out there.” He went on to describe a current example where there is an empty 100,000 square foot office building on the market for $6 million about two miles from a hospital.
“It would be perfect for an MOB,” he says. “It can bring down the cost of care tomorrow.” But the hospital will probably end up developing a $20 million on-campus building instead because procedures performed on campus are eligible for greater reimbursement.
“And then that loophole is going to disappear in the future, and then they’re going to have this high fixed asset basis,” he added. “So the incentives have to change to really get people to truly bring down the cost of care.”
Ms. Demmitt agreed, adding that hospital executives are concerned that “right now the insurance is paying them to take care of the sick people; they’re not paying them to keep people well. So they’ve got to look at shifting the reimbursement…”
Mr. Kuzmanovich asked about the impact of completed and potential vertical mergers in the healthcare industry. Some of those include Aetna and CVS, Cigna and Express Scripts, United Health Group/Optum and DaVita, and possibly Walmart and Humana.
Dr. Milne replied that the common characteristic of all of those “strange bedfellows” coming together “is a risk-bearing entity (an insurance company) partnering with a care delivery entity” to try to figure out how deliver healthcare more cost-effectively.
“We’re all brooding about the looming giant of Amazon partnering with Berkshire Hathaway, a risk-carrying entity, initially for their own employees,” he said. “But what does that look like when they start expanding out in the market?”
“And many of those delivery mechanisms do not have hospitals with beds,” Ms. Kuzmanovich noted. “Optum does not, CVS does not, Walgreens does not. So just keep in mind, delivery in care starts to take on very different perspective.”
“For those who this is your first taste of healthcare,” Mr. Winer said to the audience, “you’re probably thinking, ‘CMS, Medicare, Medicaid, multiple payers. What does it all mean?’
“Well one thing it means at a very high level is healthcare in this country has gone through tremendous change… But I think the point is, is that we’re on a journey with healthcare in this country, and nobody is quite sure where we end. And as an investor, that can get you pretty nervous, and … you’re seeing that play out in the market right now” with recent stock market declines for healthcare-related companies due to political uncertainty.
“But what I would say is that it’s a good example of what we deal with every day,” Mr. Winer said, “of trying to think about: Are the buildings we own, are the buildings you build, are the buildings you design – will they stand the test of time? Will they be what’s needed in the future?”
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