Aversion to conversion?

MORE PROPERTIES ARE BEING ADAPTED FOR MEDICAL USE

 

By Jessica Griffith

 

Developers and owners generally prefer to house medical offices either in new construction or in buildings specifically designed for healthcare tenants.

There are reasons for this: Old office buildings frequently do not have the infrastructure or ceiling height to support a medical use, and the transition from general office to medical office requires more maintenance, parking and attention to tenants.

But as demand for medical office space increases, owners are becoming more willing to convert traditional office buildings into medical office buildings (MOBs) – in certain situations.

“If it does occur, it is most likely going to be adjacent to a hospital,” says Craig Beam, regional vice president for Hammes Co. in Orange County, Calif. “The building may be suffering economically and this creates an opportunity to rehab the entire building.”

That description applies to one of Mr. Beam’s current projects, the conversion of a former GTE headquarters building in Santa Monica, Calif. Built in the 1950s, the 160,000 square foot building is across the street from St. John’s Health Center.

The hospital is developing an expansion plan, but building approvals are proving difficult to obtain and construction is expensive, so it may take five to seven years to approve the expansion, Mr. Beam says.

In the meantime, Mr. Beam says developers have not introduced a new MOB to the area in 25 years. And although the GTE building was about 65 percent leased, most of the leases were expiring within six months. Coincidentally, the major tenant was Fremont Investment & Loan, which originated Hammes’ loan to purchase the building.

“We knew we could vacate the building pretty rapidly and the hospital already owned the land under the building,” Mr. Beam says.

“The deal was more opportunistic than trendsetting,” he says. “I’ve been in this business since 1982 and this is the first conversion I’ve done. They’re still pretty rare.”

Opportunity also drove EdwardsDay Inc.’s decision to acquire an office building on Atlanta’s Pill Hill and convert it into the Glenridge Medical Center.

Like the Santa Monica building, this one was designed for a corporate tenant. General Motors was the sole occupant from 1974 until 2001, and by February 2005, GM had vacated all of its space and the 125,000 square foot building was 80 percent vacant.

Location was crucial to the success of this deal, says David Brooks, an asset manager at EdwardsDay.

The building is at the intersection of Interstate 285 and Glenridge Drive near three hospitals: Children’s Healthcare of Atlanta, Saint Joseph’s Hospital and Northside Hospital.

“We are primarily office buyers, but we saw this as an opportunity to combine medical and retail into one vertical development,” Mr. Brooks says. The ground floor will house several retailers but no tenants have been announced.

Eye to infrastructure

 

Due diligence is a necessity for any developer who is considering a conversion, Mr. Brooks says.

Floor plans are an important consideration because the layout can be difficult or impossible to change. Doctors generally design their offices either in a horseshoe or rectangular shape, and sufficient bay depth is required to meet those space needs. Shallow or oddly configured spaces will not attract many physician practices.

Not every office building will work for medical use, and not every conversion is appropriate for all medical uses. For example, it would be difficult to take a regular office building with normal-sized elevators and add a surgical center: The elevators need to be large enough to accommodate gurneys.

“If you are going to convert a building, it cannot be a catch-all for medical users,” says John McCarthy, vice president of brokerage services with United Properties in Bloomington, Minn. The company is converting an office building in Edina, Minn., to medical office.

Healthcare tenants also make additional demands on pipes and wiring.

“You need to make sure the electrical and plumbing and HVAC will support medical use,” Mr. Brooks says.

In the case of the Glenridge building in Atlanta, EdwardsDay only had to install additional water lines and convert the existing HVAC system to digital controls.

Medical tenants want more individual control over heating and cooling, Mr. McCarthy says. United Properties upgraded the heating and air conditioning systems, added electrical capacity and improved the venting system to bring more fresh air into the building.

In the case of the Santa Monica project, GTE used the building as a corporate headquarters and as a result, the investment in plumbing and HVAC was more expensive than in a typical office building. Even so, Hammes is improving the plumbing and adding an emergency generator system.

Power and water are not the only aspects of a building that require extra attention when medical tenants lease space. Everything from the carpets to the elevators receives more use and thus more wear and tear.

“You have more people going in and out of the building and maintenance and operating expenses are going to be higher,” Mr. McCarthy says. “You also have more cleaning, and biohazard cleaning, things you don’t have with a regular office user.”

By foot, by auto

Additional foot traffic is one reason owners often do not want to mix office tenants and medical tenants in a single building, Mr. Beam says. Law firms do not want their clients to continually have to ride in the elevator with sneezing, coughing patients, for example.

Traffic of another sort — automobile traffic — is an enormous factor in many medical conversions. 

“A typical commercial building requires three spaces per 1,0000 square feet of rentable space, and a medical office building requires five spaces,” Mr. Beam says. His Santa Monica building is on land leased from the nearby hospital, and the hospital extended the ground lease to allow for 111 additional parking spaces.

Mr. Brooks says his Atlanta building already has 450 parking spaces, a sufficient number at present. His company eventually may add another building and at that time, a new parking deck would be required.

In some urban areas, parking is not an issue. JOSS Realty Partners of New York is renovating a 75,000 square foot office building near George Washington University Hospital in Washington, D.C. Larry Botel, a managing partner with JOSS, says his building does not require the same number of parking spaces as a suburban MOB.

“We have decent parking but we’re also in a dense CBD with public transportation,” he says. His project also is a mixed-use renovation; at least 50 percent of the space is leased to medical tenants but the building still houses some general office tenants.

 

 

Upgrades, improvements

The dollars owners invest in medical office conversions vary widely, depending both on the original building and the overall vision for the project.

For example, Glenridge Medical Center in Atlanta features a four-story atrium. The building previously had an institutional feel, Mr. Brooks says, and his company is enhancing that central atrium to create a landscaped environment. The theme will continue outside with a healing garden to complement the park-like setting of the 7.5-acre site, he says.

In total, EdwardsDay will spend about $2 million on improvements, not counting the purchase price of the building.

Hammes will spend about $7.5 million to upgrade the infrastructure of the Santa Monica building. Those costs are important to consider when developers decide to convert office space to MOB space, Mr. Beam says.

“When people consider conversions, part of what they are looking at is the rent differential,” he says. “For a developer, that seems attractive, but by the time you finish the economics, there is a reason rents are more expensive.”

But medical tenants do pay more rent, and they tend to be stable and not move as frequently, Mr. Botel says.

The Edina building was commanding rents of about $13.50 per square foot for general office space. Medical tenants, on the other hand, are paying about $16 per square foot, Mr. McCarthy adds.

“You also get longer term leases and more stable tenants and that adds to the value of the real estate,” he says.

However, medical tenants often require additional attention. With a traditional office tenant, one person usually is in charge of real estate. In a medical practice, multiple doctor-owners will need to sign off on the deal.

Timing is another factor when considering the tenant mix. If a large number of the office tenants have many years left on their leases, it might not be the right time to convert the building. Owners also need to gauge the market correctly to ensure that an adequate number of medical tenants will show an interest in the building.

“You always have that fear—what if nobody comes?” Mr. McCarthy says.

In the case of the Edina building, many of the medical tenants came from an MOB attached to a nearby hospital. The converted building offered proximity to the hospital with lower rents than the MOB on the hospital campus.

This strategy worked. Prior to the conversion, the building was 80 percent occupied. Now that the conversion process is under way, occupancy remains at 80 percent and United Properties is adding more medical tenants.

Not quite a trend

No one expects a significant number of medical office conversions to flood the market. Most will be projects of opportunity, Mr. Beam says.

Appropriate office buildings near hospitals will remain the best options for conversion, Mr. Brooks adds.

“Doctors are moving away from hospitals to areas they can get in and out of quickly,” he says. “A building that is a straight shot to the hospital can mean one more procedure a day, and that falls to the bottom line.”

The opportunity factor remains significant. For example, Mr. Botel describes the JOSS project as a “generic, midblock building that won’t attract law firms or financial tenants.” It makes sense to market the space to medical tenants.

The scope of the projects and the inherent cost will continue to keep most developers away from conversions, Mr. McCarthy says.

He adds: “Converting to a medical office building is not for the faint of heart.”  q

Jessica Griffith is a business writer specializing in commercial real estate.