Financing & Investment Briefs (March 2006)

Why the barrier to entry?

FINDING AN ENTRY PLATFORM IS KEY FOR NEW PLAYERS

By John Mugford

 

Editor’s Note: This is the first in a three-part series of articles covering a Feb. 1 conference in New York titled: “Breaking New Ground: The Escalating Flow of Capital to Medical Real Estate.” Healthcare Real Estate Insights^™ was on hand to cover the conference, which was sponsored by New York-based Granite Partners LLC, a real estate investment banking firm with a concentration in healthcare properties, and the law firm of Heller Ehrman LLP, which has worked with Granite Partners on real estate transactions. This article presents highlights from a panel discussion regarding medical real estate ownership and development. The April and May installments will cover capital markets and value maximization strategies.

Capital is streaming into the medical real estate market at a surprising rate. It’s coming by way of more and more institutional investors looking to take advantage of the market sector’s steady, albeit unspectacular, returns and cash flow.

However, even as hospital systems have become more and more willing to sell their medical office buildings (MOBs), the barriers to entry in the healthcare real estate sector remain high. That’s because those same systems are becoming choosy about to whom they’re willing to sell their coveted assets.

The above was one of the main messages to emerge from the first of three panel discussions at “Breaking New Ground: The Escalating Flow of Capital to Medical Real Estate,” a conference held Feb. 1 in New York. The one-day event was sponsored by Granite Partners LLC, a New York-based real estate investment banking firm that has brokered more than $600 million worth of medical transactions in the past couple of years, as well as the law firm of Heller Ehrman LLP.

The first panel of the day was composed of folks involved in medical real estate from the ownership, development and management side. They were:

• § Charles Elcan, executive vice president of Health Care Property Investors (NYSE: HCP), the country’s largest publicly traded healthcare real estate investment trust (REIT)
• § Fred Faulkner of Louisville, Ky.-based Faulkner Real Estate Corp., an owner and developer of MOBs
• § Todd Lillibridge of Chicago-based Lillibridge, a private REIT with three funds of healthcare properties
• § Malcolm Sina of West Palm Beach Gardens, Fla.-based DASCO Cos., owner and developer of medical real estate that last year was partially acquired by CNL Retirement Properties

 

The panelists’ task was to explore and discuss how all of the new capital flowing into MOB acquisitions is affecting the development and ownership of such properties. They talked about a variety of topics, including: Why hospitals have been selling so many MOBs in recent years; why hospitals that sell MOBs still have such a strong say in how they are operated; why the owners MOBs need to have strong relationships with affiliated hospitals and their physicians; and why the medical real estate industry is better suited to long-term holders, as well as other related topics.

Granite’s Jeffrey Cooper, the moderator of the first panel discussion, started the session by asking why so many hospitals have been selling, or monetizing, MOBs in recent years.

As far as Mr. Elcan, of HCP, was concerned, the trend most likely started with the passage of the federal Stark laws in recent years. As a result, hospitals are now required to lease MOB space to doctors at market rates – meaning the end of discounted rents for physicians with ties to the hospitals.

Since the passage of the Stark laws, hospital systems have also experienced financial stresses due to changes in reimbursements from Medicare and Medicaid, as well as numerous difficulties with managed care, Mr. Elcan noted.

“As a result, the hospitals began looking at new ways to raise capital,” Mr. Elcan said. “And when they looked at their portfolio of properties, they realized they had lots of dollars tied up in their non-core assets: MOBs, ambulatory surgery centers and other outpatient facilities. They saw that monetizing these assets was a way to be put money back into their core assets and services.”

The barrier to entry

Even so, the panelists stressed that most hospital systems are not typically willing to sell their non-core assets to about anyone who comes calling with a fistful of dollars.

The fact that so many institutional investors were in attendance at the conference, according to the panelists, was an indication that there is indeed a barrier to entry into the medical real estate market.

“Hospitals have owned their real estate so long that just the thought of parting with it is a very difficult, personal decision at a business level,” said Mr. Faulkner, whose firm, an owner and operator of MOBs, has a close relationship with Louisville’s major health system, Norton Healthcare. “And most healthcare companies are reluctant to do anything to let go of what they consider the lifeblood of their systems, the physicians they have relationships with. That means they want to be able to trust the owners or managers of these MOBs to treat their physicians and physicians’ groups well.”

Mr. Sina said that institutional investors who do not know enough about what hospitals are going through, enough about reimbursement rates, enough about medical real estate laws and the current specialty hospital moratorium, and do not know enough about what issues are affecting physicians today might want to stay away from medical real estate.

When hospitals issue RFPs for the sale of non-core assets, Mr. Sina said typical questions often include: “How long have you been in the healthcare business? Is it your only business?”

“Because of this,” Mr. Sina said, “I don’t think there’s going to be a lot of future players and new players that are going to be here long-term. Maybe that’s just my own statement. But with the advent of partners that are advising hospitals out there, it would be a big risk for hospitals to choose a partner that doesn’t have a long history in this business.”

How to enter?

For large institutions looking to acquire medical real estate, perhaps the best way to enter the market is through a partnership with a firm already in the business, according to the panelists. Such entry-platform companies can include MOB developers, owners and managers with lots of experience and good relationships with hospital systems.

Each of the panelists’ firms, in fact, have formed some sort of partnerships with large investors, be they pension funds, REITs or others.

For example, Faulkner Real Estate in recent years recapitalized a nearly 1 million square foot portfolio it had put together on the campuses of Norton Healthcare hospitals. Faulkner brought in HCP as an investor, but did not let go of any interest it has in its management and development company.

Mr. Elcan was previously with MedCap Properties Trust, which owned a large portfolio of MOBs, mostly on HCA Inc. campuses. In 2003, MedCap agreed to be wholly acquired by HCP.

Lillibridge, Mr. Cooper said, is a company with “institutional investors in various portfolios, including one major investor, Prudential, as a platform investor in the operating company.”

DASCO, Mr. Cooper noted, in recent years sold 55 percent of its company, including its vast portfolio and management services, to CNL Retirement Properties. DASCO continues to manage the portfolio and look for development and acquisition opportunities.

“So, what is the best way for an institutional investor to get into this market?” Mr. Cooper asked the panelists.

“Aside from looking for a partner with the deepest pockets, we, as a smaller development company, were really looking for a partner who wouldn’t compete with us,” said Mr. Faulkner of his firm’s partnership with HCP. “We wanted someone who didn’t want to be a developer or operator, but an investor in the property; someone who would want us to move forward with new deals and do more business with in the future and build a long-term relationship with.”

For the long-term

The panelists added that investing in medical real estate is typically not a short-term, three- to five-year play. In fact, the panelists said that, at a minimum, institutional investors should consider acquiring MOBs as a medium- to long-term hold, starting at five to seven years.

“This really is a long-term business that’s all about relationships,” added Mr. Sina of DASCO. “It’s not very easy to get in without a platform company that you have a relationship with or have an interest in. The hospitals are really interested in selling to someone who is interested in the properties long-term. That’s why they often including a minimum hold period in the RFP.”

Institutional investors should, in other words, find a high-quality partner, or operator, that fully understands healthcare and what it means to keep a hospital happy over the long haul, Mr. Lillibridge added.

“It’s key for an institutional investor to be in bed with an operator who knows the business and knows what challenges are facing hospitals today,” Mr. Lillibridge said. “Because when this market goes south, which they all do, you’re going to want to be with the best operator – flat out.”

Mr. Sina said that DASCO previously had a relationship with Lehman Brothers, with the two making “several hundred million dollars of developments and acquisitions.”

“But like a lot of those companies, they are not long-term holders, three- to five-year holders, so we worked with them on an exit strategy,” Mr. Sina said. “Two years ago we filed to go public and shortly after that CNL Retirement Properties approached us. They’re a strong company with $4 billion in capital, 100 percent devoted to healthcare (in senior living properties), but they had not done medical office buildings before.”

The partnership is a great fit for DASCO, Mr. Sina said, because CNL is interested in holding properties for the long-term and is willing to allow DASCO to maintain its strong relationships with its client hospitals.

Mr. Cooper noted that even with the panelists’ words of warning, some of the members of audience might want to buy properties as short-term or medium-term investments.

He asked the panelists, “Is there is a place for short- to medium-hold investors?” In asking the question, Mr. Cooper noted that HCP has a financial partner in GE Capital, which he said is most likely a medium-term player.

“Our joint venture with GE has been very successful,” Mr. Elcan said. “They have very good contacts and bring us other opportunities as well, which is important to have in a financial partner.

“I think there is room for that medium-term capital. But if a company like ours aligns itself with medium-term capital, we’re eventually going to have to find someone to take out the capital because this is a long-term hold business. We’ve had properties that we’ve had in our portfolio for 21 years.”

Lillibridge recently recapitalized one of its REIT funds, as Mr. Cooper noted, because two of the financial investors had short-term goals and another wanted out of the real estate business.

“You replaced them with a pension fund that we’ll assume is a longer-term player,” Mr. Cooper said to Mr. Lillibridge, referring to the California State Teachers Retirement Fund (CalSTRS).

“That’s right,” Mr. Lillibridge answered. “I think the message you’re hearing is that this is a long-term hold asset class by nature…

“If you’re going to have more than one investor, you’re going to want to get key alignment of those investment strategies. We just had the good fortune that the market that existed for a longer-term player, a pension fund, allowed us to recapitalize that fund and create a whole new entity, a new second private REIT, if you will.”

Hospitals want control

In many cases, hospital systems are maintaining plenty of control over the MOBs they sell by retaining ownership of the land beneath the facilities. Doing so gives them the right to require buyers to enter into long-term ground leases.

As Mr. Cooper of Granite Partners noted, such ground leases can include rights of first refusal, limits on rent increases, and restrictions on what services can be offered in the facility, such as imaging. “Some even put restrictions on which doctors can become tenants so there’s no competition from other hospitals,” Mr. Cooper added.

“Considering all of these limitations, is this still a good place to make an investment?” Mr. Cooper asked the panelists.

“Certainly it’s not like getting in on one of the skyscraper deals here in this city,” Mr. Sina answered, comparing MOB deals to the New York office market. “The average MOB deal is in the $15 million, $20 million range, so you put in a few million dollars of equity and there’s simply not the opportunity for a $100 million, $200 million deal, particularly with all of the restrictions in those ground leases.”

The panelists also warned that even with the values of MOBs rising and cap rates falling, new investors in MOBs won’t find success if they increase rents too much.

“If you raise the rents and one physician gets upset and leaves an MOB affiliated with a hospital, that’s death for the investment because you lose a tenant and death for the hospital,” said Mr. Sina. “A doctor today can produce anywhere from a half-million to $3 million annually in revenues for a hospital, and they don’t want to lose their doctors.”

“So if a hospital that’s trying to sell a portfolio for, let’s say $50 million, tries to get the last few dollars out of the sale and at the same time they chase out a few doctors, they’ve made a mistake,” Mr. Sina said.

Still looking good

Despite some of the challenges that come with investing in and owning medical real estate, it is certainly an asset class that will no doubt continue to grow, the panelists agreed. For one thing, during the next five years or so healthcare construction is expected to total between $15 billion and $25 billion annually.

In addition, as hospitals continue to see increased demand for their services as the population ages and technology advances, health systems will rely more and more on outpatient facilities to provide certain services.

“Hospitals are always looking for ways to save money,” said Mr. Sina of DASCO. “And outpatient facilities cost significantly less than inpatient ones. It costs about $600 per square foot to build an inpatient acute-care hospital, where an outpatient facility will cost $150 to $200 a square foot – no doubt that that figure is higher in New York City, California and Hawaii.”

Even though the panelists detailed some of the barriers to entry for large investors, Mr. Lillibridge noted that as MOB prices continue to soar there will continue to be a place for institutional money, as long as such investors partner with a company that’s knowledgeable about healthcare.

“Having that institutional investor is key and will be for a long time,” Mr. Lillibridge noted. “Money has become the commodity.

“We’d love it if half of the all of the people in this room were hospital administrators, because we’re all looking for opportunities, acquisitions or developments. If you’re able to bring something to the table, you really have something. If you’re just looking to get into the business because you happened to read something … about what a great industry this is, it’s going to be tough sledding.” q

Next Month: HREI^™ will present highlights from the panel discussion on the state of the capital markets for healthcare real estate.

SIDEBAR

Crowded event was a sign of the times

When the folks at New York-based Granite Partners LLC announced they were planning a conference exploring the ever-increasing flow of capital to medical real estate, they wondered, naturally: How many people would show up?

As it turned out, Granite hit the nail on the head with its topic, as a capacity crowd of about 100 professionals – there were more on a waiting list – attended the conference on Feb. 1 at the New York offices of law firm Heller Ehrman LLP. The law firm has worked on transactions with Granite Partners, a real estate investment banking firm that in recent years has brokered more than $600 million worth of medical real estate transactions.

The audience included representatives from some of the newcomers to the industry, as well those looking to get into the market – pension funds, pension fund advisors, institutional investors, consultants to pension funds, real estate investment trusts (REITs), and others.

“If we would have had this conference three or four years ago, I think we would have had only a handful of people turning out for it,” Granite’s Jeffrey Cooper, a vice president involved in healthcare transactions, told the crowd. “But over the last three years or so, there’s been a sea of change of interest from capital outside of the traditional area of medical. The result is that it’s helped create a whole new asset class in real estate.” q