Columbia Roundtable (March 2006)

Healthcare real estate has come of age

INDUSTRY EXPERTS AT COLUMBIA UNIVERSITY ROUNDTABLE NOTE POSITIVE TRENDS

Editor’s Note: On Feb. 7, as part of its Real Estate Roundtable Series, the Columbia University Master of Science in Real Estate Development (MSRED) presented “Trends in Health Care Real Estate.” The event, which was held on the Columbia campus in New York and was sponsored in part by a grant from Ernst & Young LLP, featured a lively discussion by nine industry experts regarding healthcare real estate. Healthcare Real Estate Insights^™ was on hand, and we will present highlights from the roundtable in a two-part series. This article will concentrate on the panel’s discussion of medical office buildings (MOBs) and other medical facilities. Next month’s article will present highlights from the discussion of senior living.

 

H

ealthcare has been one of the fastest-growing segments of the real estate market since 2000, and that growth is likely to continue for at least several more years.

That was the general consensus of the industry experts who gathered Feb. 7 in New York to take part in “Trends in Health Care Real Estate,” part of the Real Estate Roundtable Series presented by the Columbia University Master of Science in Real Estate Development (MSRED).

The roundtable participants included:

▪ Flint Besecker, president, CIT Healthcare

▪ Jerry Doctrow, managing director, Stifel Nicolaus & Co. Inc.

▪ Brian Dowd, managing director, Rockwood Realty Associates Inc.

▪ Sandy Graves, senior vice president, capital management, Sunrise Senior Living                

▪ John Malloy, principal, John Molloy Architects

▪ Gordon Soderlund, senior vice president, DASCO Cos.

▪ Alison Wilson, vice president, Anchor Health Properties

▪ John Winer, partner, Ernst & Young LLP

▪ Murray Wolf, publisher, HREI^™

 

The moderator was Michael Buckley, director, Columbia University MSRED Program.

 

“You all know fundamentally the demographics mean that there’s a big business here,” Mr. Buckley said. “There are some big changes afoot.”

The panelists began by briefly recounting some familiar third-party statistics regarding the significant current and projected growth of healthcare real estate development, and discussed some of the demographic drivers behind that expansion.

“It’s an asset class that’s really coming of age,” Mr. Winer of Ernst & Young said. “I think it’s something that provides tremendous opportunity. Certainly the demographics support the continued growth in it.”

Then, the panel launched into a discussion of specific trends.

Mr. Malloy of John Malloy Architects noted that several factors are driving changes in healthcare facilities design: More and more services are being delivered on an ambulatory, or outpatient, basis; there has been a growing acceptance of “patient-focused” care; and increasing competition has forced hospitals to market themselves. He says those and other changes have expanded the potential for healthcare real estate.

Mr. Besecker of CIT said: “One of the biggest drivers … is medical technology.” Major health systems are under increasing pressure to upgrade technology, he said. That takes capital, he said, and the systems have been monetizing their real estate to unlock that capital.

Not ‘funky’ anymore

When Mr. Buckley asked about the creditworthiness of MOB investments, Mr. Winer said that, for a long time, MOB cap rates were in the 10 percent range – higher than cap rates for other office properties – because they were perceived to be more risky.

“There was always this perception and it was about credit and it was about sort of a funky asset class and less liquidity,” he said, but that was a misperception. “Doctors, actually, are pretty good credit. They get in there and they don’t like to move…”

As part of the continued shift to outpatient care, Mr. Winer noted that that ambulatory surgery centers (ASCs) are currently in high demand. He cautioned that surgery centers do carry some added investment and ownership risks.

“They require a tremendous amount of tenant improvement in order to be usable…” he said.  At the same time, he said many ASCs are operated by startup companies that can be less creditworthy. So if a surgery center fails, he said, those specialized tenant improvements can make it costly to retrofit the space for other uses.

“So, the good news is that these buildings have proven to be good credits, for the most part,” Mr. Winer said. “There is a very liquid lending market for them right now, and the lending community likes them. You have to be careful on some of the new joint ventures, surgery centers and other types of more clinical things that are going on in these medical office buildings.”

Mr. Doctrow of Stifel Nicolaus noted that multi-tenant MOBs tend to be less risky.

“Anxiety in healthcare today is increasing, and you need to have a sense, I think, about where your facility fits in,” he said, “and one of the advantages of medical office is you’re diversified – you’re not betting on a single tenant – which provides you with some advantages.”

Third-party development of new MOBs and monetizations of existing MOBs have been taking place for several years, Mr. Wolf of HREI^™ observed. But, he said there seems to be a growing interest in ownership on the part of physicians, which is forcing some other changes.

“We’re seeing some changes taking place in how those deals are structured because one of the things we’re finding is that physicians more and more want to have a piece of the action,” Mr. Wolf said. “They’re saying, ‘Hey, if somebody’s going to own this medical office building where I practice, why shouldn’t it be me?’”

Unique underwriting

Mr. Besecker noted that there is a wide range of healthcare real estate product types. He added that his firm categorizes them on the basis of acuity: the intensity of healthcare services being provided.

“The way you underwrite each one of those segments is different,” Mr. Besecker said. “On the lowest end of acuity – medical office building – you’re going to tend to take more traditional real estate perspectives. You’re going to look at per square foot cost. And, in the highest setting – acute care – you’re going to look at operating cash flow from the business. So, it’s going to look not like a real estate underwriting, it’s going to look like a cash flow or enterprise underwriting.”

As for the equity side. Mr. Besecker added: “If I’m an equity investor in healthcare real estate, I’m probably going to want to look for where inefficient markets occur or exist. And I would offer that outpatient surgery centers (are) probably one of those places because there’s not a lot of institutional capital that comes in and can create an efficient market because each one of these ownership structures is unique.”

“When we’re acquiring or developing a medical office building or some other form of ancillary facility on a campus – on a campus – we’re also looking at the credit of that hospital,” added Mr. Soderlund of DASCO. “We want to understand the operating performance of that hospital because the hospital is the driver of value of the ancillary real estate around it.”

Mr. Doctrow said: “One of the advantages of healthcare real estate as an asset class over, say, suburban office is that suburban office has become a commodity from both a development standpoint and a capital standpoint. So, it’s very hard, I think, to add value…”

The greater complexity – and possibly greater risk – associated with MOBs tends to yield greater returns, he said, adding that the average cap rate is about 200 basis points higher for MOBs than for regular commercial office buildings.

Ms. Wilson of Anchor Health Properties said healthcare real estate requires specialized expertise because it is more complex, highly regulated and highly competitive. She agreed that retail, office, industrial and multifamily real estate have become commodities.

“It’s also very fragmented and still very much more localized than some of those other asset classes,” Mr. Doctrow added. “So, if you were going to be an individual development entrepreneur, you can still maybe find a group of docs wanting to do one of these things that would rather deal with you than deal with some national player.”

More joint ventures

There appears to be a growing trend of institutional capital being paired with sector-specific real estate expertise. Mr. Wolf said.

“You’re seeing very experienced healthcare real estate developers around the country who are forming joint ventures with large institutional investors,” he said. “The institutional capital is seeing the opportunity in healthcare. They don’t always have the expertise. So, what they’re doing is teaming.”

For example, CNL Retirement Properties recently bought the bulk of DASCO’s MOB portfolio, as well as a majority interest – 55 percent — in the DASCO operating company.

“They have bought the expertise, so to speak,” DASCO’s Mr. Soderlund said of CNL. He also noted that by owning a majority of the operating company CNL also shares in revenues from properties DASCO manages. “That extends the reach of some of these institutional investors.”

The generally upbeat panel did sound one note of caution. Mr. Soderlund warned that not every MOB monetization is successful. He recounted how a portfolio of MOBs once owned by a major health system changed hands twice in about 15 months and, both times, the buyer had not previously owned MOBs. Those owners paid a premium, he said, and have been raising rents, which has made some physicians unhappy with the health system.

“Unsophisticated, inexperienced owners are looking at it as an investment play in a short-term horizon when, in fact, they should be looking at it as an investment play, but on a long-term horizon with that dynamic we were talking about between hospital and physician, and understanding how important those two work together,” Mr. Soderlund said.

“Physicians feed patients and revenue to the hospital, and that drives value around the whole table. And if you ignore that dynamic or don’t understand that dynamic, you create problems for yourselves and the parties involved.” ‘

Next Month: HREI^™ will present highlights from the discussion of senior living during the roundtable.