Staking a bigger claim in medical office

FAULKNER REAL ESTATE LOOKS TO ACQUIRE, DEVELOP $100 MILLION ANNUALLY

 

By Jessica Griffith

Fred Faulkner thought his years of experience as a developer of Class A office buildings would transfer easily to the medical office market.

“I thought it would be something like Coke introducing Diet Coke; I would just have a new customer base,” says Mr. Faulkner, president and CEO of Faulkner Real Estate in Louisville, Ky. “We would just take what we knew about suburban office and lay it over medical office. But the two weren’t similar at all.”

He says it took seven or eight years to get comfortable with medical real estate. Now, with multiple medical office buildings (MOBs) in his firm’s portfolio and a solid local client, Mr. Faulkner is introducing a spinoff company and plans to develop or acquire $100 million in medical office each year.

Mr. Faulkner hired David Laird, former managing director of Louisville-based Norton Enterprises, as executive vice president of the newly created Faulkner Healthcare Real Estate. Faulkner’s relationship with Norton Healthcare dates to the early 1990s, when the company developed its first MOB for what was then known as Galen Health Care.

“The relationship with Norton had the most to do with this decision,” Mr. Faulkner says. “It put us in the position to grow the healthcare division and gave us expertise in the industry.”

Timing was right

 

Faulkner Real Estate began developing office buildings in 1986, and the company, then known as HFH Inc., specialized in suburban office and grocery-anchored retail centers. Faulkner also developed large, mixed-use developments such as Landis Lakes TowneCenter in Louisville, which has more than 100,000 square feet of retail and office space.

In 1992, Faulkner developed an MOB for what is now Norton Suburban Hospital in Louisville, then purchased the existing MOB on campus and built the Women’s Pavilion. Faulkner owns all three buildings in a partnership with Health Care Property Investors Inc. (NYSE: HCP), a real estate investment trust (REIT) based in Long Beach, Calif.

The timing of that first MOB deal was fortuitous. Healthcare systems were just beginning to divest their hospital real estate, and with reimbursement rates falling, they needed new ways to be profitable.

“We were ahead of the trend instead of pursuing it,” Mr. Faulkner says. “We were fortunate in that we were already involved and committed when the market started coming into its own.”

Mr. Faulkner recognized the potential of the healthcare market at the same time that Norton was preparing to sell some of its non-hospital real estate.

“As a hospital system, you need medical office buildings,” says Russell Cox, chief operating officer of Norton Healthcare. “We never wanted to get out of our involvement with those facilities, but we wanted to take the capital that we had invested in bricks and mortar and invest it in technology and patient-centric assets.

“Our relationship with Faulkner Real Estate was a key component in our ability to grow into the largest healthcare system in the region,” he adds.

Norton also wanted to find a real estate partner and use that partner’s capital to expand its medical office space, Mr. Laird says.

“This allowed us to recruit more physicians and Norton grew faster as a result,” says Mr. Laird, who joined Norton in 1998 as senior vice president for the physician practice-planning system. He later ran Norton Enterprises, a for-profit division designed to raise capital for future needs within the healthcare system.

“In the old days, you had to build an MOB to keep medical staff at the hospital and you had to bear the expense, even if you would rather be investing in medical equipment,” he adds.

After the deal on the Suburban Hospital campus proved beneficial to both Norton and Faulkner, the company decided to expand the relationship.

“Norton has five hospitals in Louisville, and we thought if an idea worked well in one location, it would work well in another,” Mr. Laird says.

Faulkner purchased the MOB on the Norton Audubon campus and then built a second MOB, a move that attracted 33 new physicians to the hospital.

The partnership then focused on Norton’s downtown Louisville campus, home to two hospitals. Faulkner bought an MOB on the campus and is negotiating the purchase of a second building and the development of a third.

The fifth Norton campus has filed for a change in its Certificate of Need (CON) that would allow the hospital to relocate, and Faulkner is waiting for that process to be complete before considering new plans for MOBs.

Scouting new territory

 

As Faulkner familiarized itself with healthcare, one challenge was the ever-changing nameplate on Norton’s door. When the companies began the relationship, the hospitals were owned by Galen Health Care, an entity that spun off from Humana, which decided to focus on health insurance instead of hospitals. Galen later merged with Columbia/HCA Healthcare, at which time the corporate offices moved from Louisville to Nashville, Tenn.

“During this period, there was considerable inconsistency with the management of the hospitals and the relationships with the physicians,” Mr. Faulkner says. “It was only after Norton purchased all of the (formerly Galen) hospitals in Kentucky that we established a working partnership and business plan that allowed our growth.”

Meanwhile, through the acquisitions and developments on Norton’s hospital campuses, Mr. Faulkner says he learned the differences between medical office development and traditional office projects.

“The similarity with the two ends in the word ‘office,’” he says. “We went through a period from 1992 to 1997 when we questioned whether it made sense to be in this business and it took seven or eight years to develop the expertise.”

One significant difference between MOBs and traditional office buildings is the cost of interior construction, which in an MOB can cost more than the building’s shell. 

“You can’t work with a tenant improvement allowance as efficiently as you can with corporate tenants in Class A office space,” Mr. Faulkner says. “There’s more to it than a drop ceiling, a few walls and some carpet.”

A typical office building in one of Faulkner’s developments would provide $25 to $35 per square foot for tenant buildout. A medical buildout could run twice that much.

Faulkner Real Estate also learned to work with a different type of customer. Instead of keeping 9-to-5 hours, many medical tenants see patients early, late or even around the clock.

“You have different traffic patterns, different cleaning needs, different waste removal, even the mechanical systems are different,” Mr. Faulkner says.

“The key to making the rent work for the physician, and thus allowing the hospital to recruit more physicians, is designing the space effectively to keep costs in line,” he adds. “We had a pretty sizeable learning curve.”

MOB comfort-level rises

Faulkner is comfortable with MOBs now, and the company appears primed for an expansion into additional healthcare projects.

“It was almost as if healthcare was overtaking our other businesses, and that prompted us to spin off a separate company,” Mr. Faulkner says.

“We think there are many other Nortons out there and definitely there is capital out there,” he adds. “The economic climate is beneficial and hospital organizations are considering sources other than bond financing to develop medical office.”

Faulkner Real Estate worked with Galen/Norton through multiple ownership changes, but its experience is limited to that account and to the Louisville market.

As it looks to the future, Faulkner is not planning to work with Norton’s competitors in the Louisville market. Instead, Faulkner will seek new clients in first-, second- and third-tier cities. Mr. Faulkner says he would prefer to continue with his firm’s expertise in building on-campus MOBs, but the primary purpose of the expansion is to build new relationships similar to the one with Norton.

“The goal will be to find healthcare companies in need of a company like ours that offers expertise in the overall planning process,” he says. “This is a much broader strategy than just seeking the next development or acquisition property through responses to a request for proposal.”

Mr. Faulkner says he anticipates a few challenges, including the management of staff in multiple markets and the creation of communication systems that allow personnel in those markets to track and report progress.

But the company’s well-honed expertise in the industry is attractive to healthcare management, Mr. Cox says. Mr. Faulkner took time to learn about the needs of both healthcare executives and physician tenants and organized a team with similar skills.

“He created a nice bridge for us,” Mr. Cox says. “He made it a priority to stay in close communication with Norton Healthcare and with the physicians in the buildings. We wanted to keep the right mix of physicians and not worry about real estate.”

The addition of Mr. Laird will further increase the confidence of potential clients, he adds.

“David understands the daily pressures and daily struggles that hospital administrators go through related to capital and operating decisions,” Mr. Cox says.

No specific deals exist yet, but the company expects to invest $100 million per year in MOB development and acquisition.

As hospitals continue to build their outpatient business, an increasing number of healthcare organizations are exploring real estate partnerships.

“They would be wise to have a partner and not have to risk all of their equity to build patient volumes,” Mr. Laird says. q

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

Faulkner Healthcare Real Estate

Louisville, Ky.

STATS

+ Ownership: A separate, privately held company operating under the umbrella of Faulkner Real Estate Corp., also a privately held firm

+ Employees: 40, in Faulkner Real Estate Corp. The company has not determined how many will be devoted exclusively to healthcare

+ Services: Development, long-range planning, acquisition and management of healthcare-related real estate

CONTACTS

+ Fred D. Faulkner, president and CEO; David Laird, vice president.

+ Main Phone: (502) 891-8200.

+ Web Sites: www.faulkneronline.com (corporate), and www.faulknerhealthcare.com (healthcare entity)