Granite Partners Panel 3 (June 2006)

Money, money, money!

EXPERTS POINT OUT WAYS TO MAXIMIZE RETURNS ON MEDICAL REAL ESTATE

Editor’s Note: This is the final installment of a three-part series of articles covering a recent 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 the day’s third panel discussion: “Strategies for Maximizing the Value of Medical Real Estate.”

 

By John Mugford

Anyone looking to sell medical real estate today shouldn’t have to look very far for potential buyers. That’s because many institutions are sitting on money they’d love to invest in the shrinking pool of available medical-related properties.

As prices continues to rise and cap rates continue to fall for healthcare properties, including medical office buildings (MOBs), about all a seller needs to do these days to maximize returns is to offer properties in an auction-like sale.

That was one of the key messages from the third panel discussion at a one-day conference in New York in February. The conference was sponsored by Granite Partners LLC and the law firm of Heller Ehrman LLP. The title of the third session was “Strategies for Maximizing the Value of Medical Real Estate.”

The moderator of the panel was Aviva Yakren, an attorney with Heller Ehrman who provides counsel to Granite Partners on real estate transactions.

Granite’s Jeffrey Cooper, senior managing director, introduced the panelists, saying: “I’ve had the pleasure of working with all of these gentlemen at one time or another and they all are very capable and all have their own perspectives.”

The third panel consisted of:

• § Robert Falzon, a managing director at Prudential Real Estate Investors. Mr. Falzon represents third-party institutional investors as well as Prudential’s own portfolio, according to Mr. Cooper. “He runs the merchant banking section of Prudential,” Mr. Cooper said, “and the interesting thing about this is that Rob looks at investments on the entity level.”
• § Jeffrey Kanne, the managing director of the National Electric Benefit Fund. “National Electric is both an equity investor and a construction lender,” Mr. Cooper said. “They’ve got a major focus on medical office and are looking for appropriate development opportunities and development platforms.”
• § Doug Kurras, the director of strategic ventures for GE Capital. Mr. Kurras oversees GE’s venture with Long Beach, Calif.-based Healthcare Property Investors Inc. (NYSE: HCP). “One of Doug’s particular focuses is doing joint ventures,” Mr. Cooper said.
• § Frank Spencer, the president and CEO of Charlotte, N.C.-based Cogdell Spencer Inc. (NYSE: CSA). “This new public company focuses specifically on one asset area and that’s medical office,” Mr. Cooper said. “Not only has he developed more than $225 million worth of medical office buildings, but he recently took his private company and the varied entities that own the medical real estate and rolled them all up and took them public.”

 

Liquidity options

Ms. Yakren opened the discussion by asking about all of the current liquidity options for owners of MOBs.

In order to provide background, Mr. Spencer noted that his company was founded 34 years ago by James Cogdell, whom Mr. Spencer said, “really pioneered, in a lot of ways, the physician, multi-tenant physician investor market.”

“We clearly saw the trends that we’re all talking about in today’s market a number of years ago and began looking for ways to bring additional capital and liquidity to our business strategy,” Mr. Spencer said. “Our strategy had been built around physician investment. At the time we did our rollup, we had 31 different entities owning 45 multi-tenant facilities.”

In considering options, Cogdell Spencer looked at a number of private equity funds – but had a problem with their investment horizons.

“We’ve been long-term holders and an accumulator of strategic assets,” Mr. Spencer said. “We were afraid of what the short-term private money would do in terms of our business strategy.”

As a result, Mr. Spencer said his firm chose to go public, with the belief that it could accomplish its long-term goals without feeling the pressures of meeting internal rate of return (IRR) expectations faced by private firms.

Even though Mr. Falzon said he has not worked in the public markets for some time, he said he believes there should always be a place for real estate in the public markets.

“It might not appear to be that way today,” he said. “But… you have to look at the ebb and flow of capital in the market. I consider myself to be more of a capital markets guy than a property guy, and a lot of our decisions are based on what’s happening in the larger market and its influence on real estate, including this particular property type.”

“The good news,” Mr. Falzon added, “is that cash is all over the place.”

Options for accessing that cash, Mr. Falzon, said are almost unlimited.

“You name it,” he said. “You can finance up to 90 percent plus, re-capitalize and get your equity off the table and just ride your profits. You could flip this stuff into joint ventures and pension funds. You can take companies public and do joint ventures with public companies… There’s an unprecedented amount of liquidity and that’s had repercussions on pricing, as we’ve all seen.”

Mr. Kanne told the crowd that those looking to capitalize on all of the capital available today are limited only by their creativity. “Anyone who wants to sell something and get good money out of it is going to get good money out of it,” Mr. Kanne said.

JVs are the rage

Ms. Yakren then asked the panelists to discuss the JVs being formed in today’s market. She asked about the risks, or pressures, such as the tightening of government reimbursements, that are being placed on partners or investor in such ventures.

Mr. Kurras of GE Capital answered, “From a government standpoint, we are really relying on our operating partners for the day-to-day business… We have equal voting rights with our partners and it’s either going to work or not going to work; we’re not going to tell them how to run their business.”

Mr. Kanne told the crowd that the National Electric Benefit Fund has been investing in real estate and real estate development of most property types since the 1930s. It got involved in medical real estate just four or five years ago. And even though it was naïve about the property type, it’s made a lot of money.

“Our basic goal is to find the best partner who we think is an expert in their field,” he continued. “We made the strategic decision to get into medical related real estate even though we really didn’t know what we were doing at the time. In this case, we partnered with an advisor to set up a fund that would ultimately have more people than just us investing. When we kicked it off, we bought a bunch of medical office projects. In the process of all that, we stumbled into a lot of money.”

Mr. Kanne said his company’s perspective is long-term, even though there is so much money available to sellers.

“It’s a little frustrating for us now,” Mr. Kanne said. “But we think… we are uniquely suited to partner with private developers. Strategically, we have a very long-term perspective and can provide a lot of capital.”

Mr. Kanne said the company is going to invest between $200 million to $250 million in the sector, “at $2 and $3 million dollars a pop on a leveraged basis.”

“That’s going to take us a long time, but we’re okay with that,” Mr. Kanne said. “If it takes 10 years to get our money out the door, we’ll do that.  But we have, I think, a unique ability to stay with an institution, to stay with the relationship, and I still think this is a very relationship-driven business.”

Mr. Falzon noted that he’s seen a variety of JV structures emerge, and he’s often surprised by how much control the operators have in such partnerships.

“I’ve seen deals out there where it’s a return of capital and then it’s a 50/50 split on the development deal,” he said. “You stand back and you say, ‘I’m putting up all the money, so you’ve got to be kidding me?’ But that’s where the market is, and that’s across almost all real estate. It’s not just in the medical sector.”   

He said he acknowledges that operators do have more leverage and rights in the medical real estate sector than in others. That’s simply because in the medical sector “you need the operators, which means they can negotiate those types of provisions. It is definitely something to consider if you’re getting into this business.”

 

Long-term vs. short

Ms. Yakren then asked the panelists what impacts long-term verses short-term holds are having on the JV structures in which they are involved. 

Mr. Kurras of GE Capital said, “If you’re looking at value-creation type assets, such as an MOB that you’re purchasing from a hospital system where you need to make some changes in the leases… you’re going to create a lot of value.”

Once value is created, some operators will want to sell, while others will want to hold on to such assets, Mr. Kurras added.

Mr. Kanne said he believes in holding MOBs for more than just a short-term gain.

“With a few strokes of a pen, you may have an asset that’s not as liquid… if the government does something you don’t like,” he said. “So we think you should look at it and hold it long-term… and you need to decide to do with someone you can stay with long-term.” 

Get over it

Mr. Falzon, however, said holding medical real estate for the long-term does not always make sense – even if that’s what the hospitals want.

“You know if you really want this market to be an institutional market over the long-term, as opposed to a phenomenon with too much cash and too little real estate, like it is now – you’re going to have to get over this issue,” Mr. Falzon said.

“I understand that the hospital is concerned about long-term ownership,” he continued. “But frankly, I think [the hospitals] are actually concerned more about long-term management than they are about long-term ownership… often times the management is dismal. So if you want to maintain cap rates that are close to the cap rates of commercial properties, and you want to maintain liquidity in this marketplace, institutional investors are going to need to know that they can get in and can get out.”

Mr. Falzon added: “Most of our funds are open-ended… but guess what? About every four years, we turn our profit. That’s the average life of a hold in an infinite-life portfolio. It used to be about seven years and now it’s four years. So even open-ended funds are churning portfolios.”

“You know all hospitals talk about how they want [owners] to be there long-term,” added Mr. Falzon. “Incidentally, you are the highest bid for this property, right?”

Mr. Kurras countered by adding: “What we see with some of our partners is that they don’t have just one JV partner, they may have five or six or even more than 10. There’s a different capital partner for every investment profile.”

“We tend to do the shorter-term value creation,” Mr. Kurras explained. “By shorter term, I mean it’s a five- or six-year hold; not a three-year hold. It takes time for this all to create value.” 

Auctions vs. negotiated sales

As the panelists discussed the selling of medical properties, Mr. Kanne noted that his firm rarely competes with others to acquire properties. Instead, it creates value through investing in development properties, holding them and then, when the timing is right, selling.

“According to what I see today, I wouldn’t negotiate any sale – I’d be auctioning everything I own,” said Mr. Kanne.

Mr. Kurras agreed. “I think you achieve the highest price through a public auction. My preference would be a negotiated deal, but that’s not what we’re doing.”

Mr. Falzon said Prudential prefers to acquire properties through negotiated sales, but likes to sell them through an auction-like process.

Mr. Spencer said that even in the current environment, Cogdell Spencer is buying, not selling. The firm is on the watch for two types of opportunities: under-managed properties where it can create value; and beachhead acquisitions in which it might pay a bit more to gain a foothold on a hospital campus.

“We can then focus on growing a client,” Mr. Spencer said of acquiring on-campus facilities. “Seventy percent of our development deals come from our existing client base. If we can acquire a new relationship through an acquisition, we believe it will create shareholder value over the long term.”

On-campus vs. off

Ms. Yakren followed up on Mr. Spencer’s notion about the importance of gaining a foothold on a hospital campus. She asked bout the price difference between on-campus and off-campus facilities.

“I would place it somewhere in the range of 25 to 50 basis points higher to be on-campus,” Mr. Kurras answered. “The more important factor is, What campus will you be on? Is it the number one or number two hospital system in that market? Then again, if you are in an off-campus asset that is in a great retail location or a destination position, that puts you on a different par again. You have to look at every situation differently.”

Mr. Kanne disagreed, somewhat, by saying: “From our perspective, we would pay more and expect a significant return – maybe 100 basis points more to get on a good campus with a good hospital.”

Mr. Falzon, however, added that he’s finding a difference of about 50 basis points between on-campus and off-campus. “You would think there would be a larger premium to being on campus,” he said. “But it isn’t always there.”

Mr. Falzon also noted how much cap rates have changed in the last decade for MOBs. Back in 1997, he said his firm was getting 10 percent to 12 percent yields on medical real estate acquisitions.

“We got to the point where we were raising the rents and getting an even better yield,” Mr. Falzon added. “We kept buying at lower and lower cap rates and then, as cap rates kept dropping, we probably passed on some things we should not have… Smart guys buy when cap rates are at 10 percent and watch it ride down to 7 percent – that’s when you’ve made a ton of money. So what if you’ve overpaid by 500 basis points?”

Cap rates will have to climb at some point, Mr. Falzon said, adding that they will follow the lead of rising interest rates. q