Market Focus- San Francisco (April 2006)

By Ann Bretts


Call it what you will: Senate Bill 1953, the state’s seismic safety codes, or, simply, SB 1953.

Whatever the term, anyone involved in healthcare real estate in San Francisco – or anywhere in California, for that matter – the 2008 deadline for bringing acute-care facilities into compliance with the seismic regulations is on everyone’s minds.

With just two years to comply – or to apply for an extension to 2013 – providers, architects and contractors are burning the candle at both ends, trying to get new projects completed as they lobby the California Legislature to give them more time.

SB 1953 was passed in 1994 in the aftermath of the devastation wreaked by the Northridge Earthquake. In effect, the regulations mean that about half of the state’s acute-care hospitals need to be replaced or retrofitted. Many systems are struggling to comply, especially those with hospitals in cities and areas where land is scarce and expensive.

In addition, health systems are scrambling to keep up with the healthcare demands of a growing population. Working on so many facilities at the same time has created a bureaucratic backlog for state project approvals, fierce competition for contractors and has had an impact on record-breaking construction costs.

“When the guidelines were first passed, they were so far out that people didn’t take them seriously,” says James Moloney, managing director at the San Francisco office of Cain Brothers, a New York investment bank specializing in healthcare.

Moloney says the California hospital industry is united right now in lobbying for delays, but that may not last. He estimates that only about 20 percent, or slightly more, of the state’s hospitals will meet the 2008 deadline.

“What I think is that as that number approaches a 30 percent rate, you’ll see a separation of the lobbying interests, so that the [providers] in compliance are going to become advocates for more rigid compliance,” Mr. Moloney says.

The cost of waiting

Even if providers win a delay, they’ll undoubtedly pay a high price for it.

The California Hospital Association has boosted its estimate of the total cost of meeting the new regulations to $60 billion, up from earlier estimates of $24 billion to $40 billion.

A January report by Davis Langdon Seah International, a worldwide construction cost consulting group, explains the increasingly grim scenario for health systems needing to financing new projects.

Peter Morris, who, as a principal with Davis Langdon, prepared the report, says construction costs for healthcare facilities in California have increased from $330 per square foot at the start of 2003 to $550 per square foot in January 2006. That’s an increase of 18.5 percent per year.

The report indicates that costs for general construction in California have grown in the 12 percent to 15 percent range for each of the last two years. In addition, Mr. Morris says healthcare construction costs in California in 2006 will far outpace the rest of the country, which Morris estimates will stay below $400 per square foot.

Mr. Morris blames only a small part of the increase on the cost of materials, saying instead that the construction boom and the massive size of the healthcare projects have created fierce competition for the limited pool of contractors big enough to handle the work. Planning and construction schedules, bureaucratic delays and complicated increase risk and cost for contractors. Mr. Morris estimates that on a $100 million project, a one-month delay can add as much as $2 million to the cost.

Sticker shock

Announcements of new hospital developments are causing sticker shock, even for jaded Californians, with several projects breaking the $1 billion mark. Even HMO giant Kaiser Permanente finds itself looking for ways to cut costs without cutting quality.

San Francisco, one of the hottest real estate markets in the country, is feeling the impact in a big way. For example:

• California Pacific Medical Center in San Francisco hit the $1 billion mark with its plans to build, renovate and integrate three neighboring campuses in the Mission District. Skidmore, Owings & Merrill LLP and SmithGoup and SMWM have created a joint venture to tackle the project for Sutter Health, which owns CPMC and last year took over the financially-strapped St. Luke’s Hospital. The health system also bought an aging hotel to renovate as additional medical space for the campus and to move services so other areas can be renovated.

 • San Francisco voters in 1999 approved a $299 million bond measure to replace Laguna Honda Hospital. Cost estimates now are $600 million. The current plans call for space for up to 1,200 residents, but there is controversy over whether large facilities are the right answer for long-term care.

• A city advisory committee recommended last fall replacing the 547-bed San Francisco General Hospital on its current site in the heavily developed Mission District, a project estimated at $800 million or more. Mayor Gary Newsom has delayed a public vote on a bond issue. The mayor has included $25 million in his budget proposal to develop plans that will help pin down a price that can be justified to voters.

Big players, big plans

Oakland-based Kaiser Permanente, the largest HMO in the country, plans to spend $10 billion in Northern California on 30 new construction and expansion projects over the next seven years.

Some work is related to the seismic safety regulations while other projects are planned to handle Kaiser’s growing HMO membership, which now totals 6.2 million across the state. Kaiser, which has 19 hospitals and nearly 50 medical office buildings, plans to add hospitals in Antioch, Vacaville and Modesto and replace its Oakland hospital with a larger facility. In Santa Clara, Kaiser is replacing an older hospital with a new $400 million, 327-bed hospital. It already has completed work on adjacent medical office buildings (MOBs).

All of Kaiser’s facilities in the San Francisco area meet seismic regulations, but the company is planning a $30 million cancer center in South San Francisco that’s set for completion in 2007. Kaiser also has big plans in surrounding communities.

The company’s largest project in the area is a $375 million replacement hospital and adjacent MOBs at Santa Clara Medical Center, near San Jose. San Francisco-based Anshell+Allen is designing the facility, which will have a total of 1.2 million square feet divided between the hospital and the new MOBs.

Kaiser also is tearing down an MOB in Oakland to make room for a 346-bed hospital. It will tear down an auto dealership to build a 150,000 square foot medical office building.

Perhaps taking a page from national retailers, Kaiser is developing templates to use in up to 10 hospitals by 2013. The hospital templates can be adjusted for facilities from 150 to 300 beds, each with outpatient support centers. Chong Partners Architecture and SmithGroup were responsible for developing the first three Kaiser hospitals to use the templates; the hospitals are currently under construction in Antioch, Modesto and Sand Canyon.

Another Northern California powerhouse, Sacramento-based Sutter Health is holding its own in the construction race. Sutter, which operates 27 hospitals in the northern part of the state, announced in March that it plans to spend $6.6 billion on construction though 2017. That’s $1.7 billion more than the provider estimated when it first laid the plans five years ago.

Sutter officials say the increases reflect not just the costs of complying with SB1953 but an expansion of services and a shift to more outpatient facilities. Details were not available for all of Sutter’s projects, but plans include new or expanded outpatient centers and medical offices in Fairfield, Mountain View, Fremont, Tracy, Auburn, Jackson, the greater Sacramento area and the San Joaquin Valley. Hospital projects are under way or planned in Santa Rosa, San Francisco, Oakland/Berkeley, Burlingame, San Carlos, Sacramento and Elk Grove. Other projects could be named later.

Sacramento story

The big healthcare names in Northern California — Kaiser and Sutter – compete quite heavily in Sacramento and the surrounding area.

In December, Sutter gained city approval for its plans for a new $460 million renovation and expansion of Sutter General Hospital.

The plan includes a new 250-bed hospital for women’s and children’s services and a 150,000 square foot MOB across the street from the existing hospital. Renovations include a new emergency room, 25 new operating theaters, a new radiology department and new administration and cafeteria space.


Kaiser’s building program includes $166 million in hospital construction and a $138 million MOB at its Kaiser Roseville Medical Center, in the Sacramento suburb of Roseville, Calif. The provider has also started construction on a two-story, $37 million MOB in Lincoln, north of Sacramento in growing Placer County.

Kaiser and Sutter also have new construction and renovation plans in Placer County, northeast of Sacramento, one of the fastest growing counties in the state.

The University of California Davis Medical Center, west of Sacramento, is in the midst of a major construction and renovation process that began in 2004 and will run through 2011. Projects include demolition and replacement of parts of the hospital as well as a new same-day surgery center and education center.

New options in elder care

California has cultivated an image of itself as a land of eternal youth, yet even its residents are getting older. In true California style, however, Bay Area developers are finding success with projects that reflect a new approach to senior living.

“We’re seeing the traditional CCRC (continuing care retirement community) evolve in very interesting ways,” says Rob Steinberg, president of the Steinberg Architects of San Jose. “People are living long, they’re interested in lifelong learning and interested in being part of the community,” Steinberg says.

Steinberg is tackling an ambitious project right now, designing the $250 million Taube-Koret Campus for Jewish Life, to be located on 8.5 acres of the former Sun Microsystems headquarters site in Palo Alto.

Several major Jewish organizations are combining forces to create an integrated, multi-generational campus which will include a community center, cultural center and a 200-unit retirement community with independent living and multiple levels of care.

The project, set for a fall 2006 groundbreaking, also is designed to coordinate with a Jewish high school nearby and an adjacent 100-unit market rate townhome project developed by a separate community organization. Steinberg’s firm recently teamed up with Classic Residence by Hyatt, an affiliate of the familiar global hospitality business.

Classic Residence serves more than 5,000 residents nationwide in 18 upscale senior communities, three of them in California. Steinberg’s project, the newest, opened in late 2005 in Palo Alto with 388 independent units, 70 asisted living units and a 59-bed skilled nursing facility integrated in one campus.

The rental development offers the usual amenities, plus perks such as fine dining and concierge services. General contractor was Milpitas-based Devcon Construction, Inc., with hard costs pegged at $180 million and Hyatt reporting a total cost of $370 million.

MOBs in flux

Throughout the industry, hospital construction can be a boon for the MOB market. Providers are able to streamline hospital projects by moving more outpatient and clinic services out of their plans and into those of private landlords.

So far, however, this has not been the case in San Francisco.

“We’re not seeing a lot of development of MOB space,” says Mr. Moloney. “Real estate is really expensive and none of the hospitals have resolved what they’re going to do to meet the seismic guidelines.”

Because the state is only requiring the replacement of trauma centers and acute-care facilities, some hospitals may opt to build enough new space for those services and convert existing space to outpatient and clinic services.

Mr. Moloney says that throughout the country MOB developments are generating annual yields of 7 percent to 9 percent. Such projects have some significant advantages over general offices, largely because the tenants, both doctors and healthcare systems, are stable, credit-worthy, long-term leaseholders who pay rents on time.

Conventional office tenants usually sign leases for three to five years, with an average 60 percent renewal rate, while doctors usually sign leases of up to eight years, with 90 percent renewal rates. Companies increasingly work by phone and Internet, making it easy to shift office locations. Acquisitions, consolidations and outsourcing also can make critical space useless overnight.

Doctors, however, still depend on their relationships with their patients and other health care providers in a specific geographic area. They also invest heavily in equipment and custom finishes, and tend to take very good care of their facilities, so they have little incentive to incur the cost and disruption of moving.

Mr. Moloney says his firm’s recent research illustrates the success of MOBs in San Francisco’s Class A office market. Between 1999 and 2004, after the collapse of the dot-com industry, Mr. Moloney found that net effective rents increased to $34 per square foot from $28 per square foot for medical offices, with cash flows rising 22 percent. During the same period, conventional office space rents sank to $25 per square foot from $50 per square foot and cash flows fell almost 80 percent.

The next few months will provide some clarity as the State Legislature decides whether to extend deadlines or otherwise modify SB 1953. Still, the question isn’t whether health systems will have to comply with tougher earthquake safety standards, but when, and at what cost?

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