Are current ownership models just fads?

BOMA’s MOB CONFERENCE EXPLORES PHYSICIAN OWNERSHIP, CONDOS, OTHER OPTIONS

 

By Murray W. Wolf

 

Is physician investment in healthcare real estate here to stay? Are medical office condos a good investment for doctors? Will rising interest rates cool physicians’ ardor for medical real estate investing?

These and other questions were discussed in depth during a panel discussion at the “2006 Medical Office Building and Healthcare Facilities Seminar” held June 22-23 in Dallas. The two-day event was sponsored by BOMA International. The title of the panel discussion was “Current Ownership and Use Models for MOBs and Related Facilities.”

The moderator of the panel was Brent D. Tharp, senior vice president of originations for GE Healthcare Financial Services (GE HFS).

The panel consisted of:

• § Andrew “Andy” Johnston, senior vice president, development, for United Surgical Partners International Inc. (Nasdaq: USPI). USPI is an Addison (Dallas), Texas-based developer, owner and manager of ambulatory surgery centers (ASCs). Mr. Johnston is involved in development and acquisitions of ASCs, formation and management of partnerships with not-for-profit hospitals and health systems, and new projects.

 

• § William “Bill” Maggard, a partner with Mercatus Group LLC. Mercatus is a Vernon Hills (Chicago), Ill.-based firm that develops and operates MOBs that include shared ancillary medical services such as imaging, labs and physical therapy, and shared business operations, such as patient and practice accounting. Mr. Maggard a healthcare real estate development executive.

 

• § Jean-Claude Saada, chairman and CEO of Cambridge Holdings Inc. Cambridge is a Dallas-based developer, owner and manager of medical facilities. Mr. Saada is Cambridge’s founder and he focuses on working with health system executives to develop new facilities as a component of an integrated business strategy.

 

• § Andrew E. “Drew” Shearer, chief operation officer and managing director of real estate development for Development Solutions Group LLC. The Denver-based firm is a real estate development and consulting company specializing in healthcare facilities. Mr. Shearer specializes in a range of commercial real estate-related services, some of which include strategic business planning, development, and the structuring of financing and ownership entities.

 

• § Peter Spier, vice president of development for Plaza Cos., based in Peoria (Phoenix), Ariz. The commercial real estate firm specializes in the development, leasing, marketing, ownership and management of medical/research office properties and senior housing. Mr. Spier is responsible for development projects in the bioscience, biotechnology and medical office sectors.

 

ASCs are on the rise

Mr. Tharp of GE HFS got the ball rolling with some facts and figures that provided a brief overview of healthcare industry trends:

• § Despite a growing, aging population, the number of U.S. hospital beds declined to about 830,000 in 2004 from about 1 million in 1984.
• § The number of ASCs increased to 4,355 in the third quarter (Q3) of 2004 from 2,425 in 1996 from one in 1970.
• § The percentage of surgery performed in freestanding ASCs increased to 38 percent in 2005 from 4 percent in 1981.

 

“In addition, of that 38 percent, 70 percent are investor-owned ASCs, which means … there’s not hospital ownership of that ASC,” he said. “It does have an impact on what’s going on in MOBs…” He added that 55 percent of freestanding ASCs are multi-specialty centers.

Citing other statistics from a variety of sources, Mr. Tharp noted that average MOB capitalization rates declined to slightly more than 7 percent during Q4 2005 from a high of about 9.7 percent in 2002. MOB transaction volumes increased to more than $2 billion in 2005 from about $600 million in 2000, and MOB development increased to almost $1.5 billion from about $500 million during the same period.

Although hospital construction spending increased to about $1.3 billion in 2004 from about $1 billion in 2001, the hospital bed supply declined during the same period.

‘Necessary evil’ no more

Next, Mr. Saada described the changes he has seen during two decades or so in the healthcare real estate business.

“It wasn’t too long ago – some 20 years ago when I started Cambridge — that nobody had heard of medical office buildings…” he said, adding that they were considered “a necessary evil” for most hospital systems.

“A lot has changed in the last 20 years,” he continued. He noted that the amount of healthcare facility development has soared despite the fact that the number of hospitals has declined during the period – from about 7,500 down to about 5,000.

Changes in technology that have allowed more and more healthcare services to be delivered in an outpatient setting have changed the marketplace, he said. Changes in the reimbursement system have also made outpatient procedures more economically attractive.

“That has led to a tremendous amount of obsolescence,” Mr. Saada said. “Obsolescence as we see it is not only just in the hospital beds and how healthcare functions in hospitals, but it’s also in medical office buildings.” Not only are older buildings less efficient for physicians and staff, but increasingly demanding patients “are refusing to go to drab old facilities with white walls and ugly surroundings,” he said.

“That’s important because patients eventually will rule. Consumers will rule. This is America, and American consumers do have rights, and we do need to listen to what consumers are saying…”

Cost containment efforts by hospitals and health systems have resulted in the sale of non-core assets such as MOBs, he added.

“We’ve seen hospital systems putting their portfolios on the market, which was unheard of 20 years ago,” Mr. Saada said. “That was heresy 20 years ago for any hospital system to sell anything.”

Competition between providers has also increased, resulting in “turf wars” waged through renovations and expansions of existing campuses as well as new construction in new markets.

Physicians have also played a role in the changing healthcare real estate environment, he said.

“Physicians have been up in arms for a long time over being deprived by either the hospital system or insurance or Medicare as to what they can make and how they can make it. And their voices now are being heard. They’re being heard through partnerships… they’re being heard through syndications of real estate, they’re being heard across the board,” Mr. Saada said.

“And, frankly, they want a piece of the pie.”

Although many of these changes were “more of an evolution than a revolution,” he said, they have profoundly affected real estate fundamentals, such as cap rates.

Referring to the steady decline in hospital beds, Mr. Shearer of Development Solutions Group added: “That trend seems to be upside down. When you think of 80 million Baby Boomers aging and dying over the next 25 years, you would think there’d be a lot more acute care development.”

But he noted that a recent study projected that there would be only 8 percent growth of acute care through 2015, while outpatient care was expected to grow by more than 40 percent.

Five ownership models

The various healthcare real estate ownership models can be described in terms of who develops, owns and manages the facilities, Mr. Shearer said.

Hospital ownership. The traditional model, he said, is for a hospital to develop facilities using in-house staff. The hospital also continues to own the property. The facilities are often managed by in-house staff, or sometimes by third parties.

Institutional acquisition and ownership. The next model reflects the recent trend toward the monetization of non-core assets, Mr. Shearer said. Under that model, an institutional investor acquires existing hospital properties – although institutions can also get involved in development. These properties are usually managed by third-party asset and property managers.

Third-party development, ownership and management. This scenario can take many forms, he said. Most – but not all – of these developments are on campus.

Medical office condominiums. Under this model, developers typically develop relatively small buildings or groups of small buildings for relatively small tenants – clients in the 3,000 square foot to 10,000 square foot range, according to Mr. Shearer. The developers are responsible for the building shell and site improvements; buyers are responsible for interior improvements. Buyers can move in quickly – often within three to six months. Physician groups are typically structured as a partnership, and a separate partnership is formed to own the condo unit. The medical practice pays rent to the real estate partnership.

Owner occupied buildings. In the instance of owner-occupied or build-to-suit medical buildings, a physicians’ group often acts as the developer. These facilities can be on or off campus, in partnership with a hospital or not, and with or without third-party management.

Mr. Shearer said that the prevailing model of ASC and specialty hospital development has changed over time.

“The old model for that was that was a group of surgeons wanted to go start a specialty hospital or a surgery center, and got into a battle with their hospital, they left the campus, did the project off campus, the hospital didn’t like it, it strained the relationship and there was kind of a war going on,” he said. Historically, those have tended to be relatively small projects – in the 20,000 square foot to 40,000 square foot range – with no hospital involvement in the ownership, development or tenancy.

“We’re seeing that changing dramatically,” Mr. Shearer said. “In fact, most of our deals now are hospital JVs with groups of docs.” A wide range of facilities are being developed in this way, including MOBs, ASCs, imaging centers and various specialty centers. Sometimes they’re grouped “almost like a big-box retail analogy.”

These facilities are frequently being built off-campus in new markets by third-party developers. These private sector-funded facilities enable hospitals and health systems to preserve capital.

Dealing with docs

Physicians have a reputation for being demanding in their business dealings, which can add complexity for developers who partner with medical practice groups for healthcare real estate projects.

“I’m sure you’ve all heard that (if) you add physicians to the mix it becomes complex – on the real estate side in particular when you have professional real estate investors partnered with non-professional investors,” said Mr. Maggard of Mercatus. But, he added, his firm deals with even greater complexity because its business model is to partner with physicians on more than just real estate.

“The complexity of our model is enhanced because it’s not just a partnership with physicians on the real estate but we are aggregating physicians around our physician centers as part of our culture of supporting independent physicians,” he said. “And we partner with physicians on ancillary services and business services that are located within our physician centers.

Mr. Maggard said that Mercatus has essentially set up three companies: development, ancillary services (diagnostic imaging, physical therapy and clinical labs) and business services (software applications for electronic medical records and electronic practice management).

 “So, we’re at the extreme end of complexity,” he said, “and, culturally, we have an affinity toward partnering with physicians.”

Mr. Maggard said that he sees a trend toward more partnerships between hospital sponsors, developers and physicians, and it’s only going to get more complex.

“So it’s a daunting task but we think that the trend is toward greater collaboration, greater partnership, and there’s really no avoiding that in this industry.”

Physicians want equity

“We’re getting more and more interest from our physicians in owning real estate,” said Mr. Johnston of USPI. The firm has ownership interests in or operates 128 surgical facilities – all with physician investors and about half of which are jointly owned with not-for-profit health systems, Mr. Johnston says. But USPI only owns and operates outpatient surgery center businesses; it does not own the real estate. USPI works with third-party firms to develop the facilities.

With reimbursement rates shrinking and managed care on the rise, physicians have for many years sought ways to supplement their declining incomes, Mr. Johnston said. About 10 or 12 years ago, he began helping doctors figure out ways to supplement their incomes with healthcare business ventures, such as outpatient surgery, imaging and physical therapy centers.

“What’s interesting is that, today, 10 or 12 years later, the same conversation is absolutely true, if not more true, and the physicians who have developed those centers and have derived that additional income now see that as just part of their income, and they’re wondering what’s next.”

Increasingly, the “what’s next” is physician investment in real estate, he said.

During the past decade, Mr. Johnston says USPI seen physicians wanting more ownership and control. Ten years ago, USPI would partner with the hospital and together the two entities would set aside perhaps 10 percent to 20 percent ownership interest of the surgery center business for physicians.

“Now it’s reversed,” he said. Today’s physicians tend to want majority ownership of the business – often 100 percent. The same thing is probably happening on the real estate side, he said.

“Every single time we develop a center now, the physicians are asking, ‘How do I own the real estate?’” Mr. Johnston said. “We didn’t have that two years ago, three years ago, four years ago. It’s almost every single time.”

Smart hospitals and docs

There are still some hospital systems with policies against physician ownership,” Mr. Shearer said, but that’s usually only where they have a monopoly.

“In a competitive environment, smart hospital systems understand that there aren’t any hospitals without doctors,” he said.

“I think most hospitals have come to the conclusion that they can’t build a surgery center – certainly a freestanding surgery center – without physician investment,” Mr. Johnston added.

Although some hospitals have tried to monopolize the local market, he said, “I think those sorts of responses are getting fewer and fewer.” Hospitals that don’t embrace physician ownership “are putting their heads in the sand,” he added.

Even so, the trend cuts both ways, Mr. Saada noted.

Physicians might want to develop their own facilities, but in some markets – such as California, where developers must contend with high land prices, high construction costs and state seismic safety standards – it can be cost-prohibitive to develop healthcare real estate without the support of the hospitals.

How close is too close?

An audience member asked the panel how close a third-party, off-campus healthcare facility should be to a hospital. That depends on the situation, the panelists said.

And the nature of the project is more important than the proximity, Mr. Tharp noted.

 

“I think your greatest risk is that you have doctors who create an MOB or some other kind of structure that competes head on with the same doctors who are at the hospital,” he said. If the hospital perceives the facility as a threat, “they may build something that competes directly with what you have.”

The more important the hospital is to the physicians determines how much influence the hospital will have, he continued. It also depends on the type of off-campus facility. He said that hospitals will probably view general practitioners as being the least competitive with their service offerings, whereas other services, such as surgery, could be viewed as directly competitive.

Mr. Spier of the Plaza Cos. recommended that would-be developers study a hospital’s campus master plan to identify potential niches they might fill. Sometimes hospitals have restrictions on the types of services they can provide, and that can spell opportunity in an outpatient development.

“The same restrictions that they have on their campus could drive a lot of physicians straight to your project,” he said.

Condos and exit strategies

Another audience member asked: What, with all the interest in physician investment, are the exit strategies for doctors that put money into real estate?

Again the scenarios vary, the panelists said.

For buildings owned and occupied by a single medical practice group, a long-term holding period might be in order. But for multi-tenant buildings owned by an investment partnership, the deal might be structured for a relatively near-term sale.

Physician investors in multi-tenant buildings might want to sell when there are long lease terms remaining, Mr. Shearer said. That way there is less potential for the buyer to absorb the cost of TI for new tenants, giving the buyer less negotiating leverage.

It also depends on the user. Older physicians who are nearing retirement might not want to tie up their money in real estate, whereas younger doctors might be more inclined to invest because they expect to use the facility for a longer period.

When it comes to medical office condos, the panelists cautioned that some physicians can have unrealistic expectations about appreciation and the ultimate sale prices. In many instances, they don’t realize that a buyer will probably need to make a significant investment in renovations and tenant improvements – sometimes up to 50 percent of the appraised value – and that’s probably going to cut into the sale price.

“That’s why I think the condo market is a bit of a misconception,” Mr. Shearer said. Developers will sell a core and shell building for $250 per square foot to $300 per square foot, he said, then the condo buyer puts in another $100 a square foot into improvements, for a total of $350 per square foot to $400 per square foot. It might be difficult for doctors to recoup that cost when they sell.

“Condominiums, by and large, historically, have seen more of a decline in value than upside. That’s the reality,” Mr. Saada added. Condos are hot now, he said, but he’s seen the ups and downs during 18 or 20 years in the real estate business.

Mr. Saada noted that while condos can look attractive up front from a cost standpoint, physicians should also consider the superior value that could be provided by a better designed, more efficient facility.

“When you’re putting the value proposition together, it’s not just about real estate,” he said. Over time, costs savings from improved efficiency can more than make up for a lower real estate cost, he said.

Mr. Saada also noted that some potential buyers are currently willing to buy MOBs with cap rates of less than 7 percent, 6 percent or even 5 percent. He implied that sellers should probably grab those deals if they can get them.

“It won’t happen again for a long time,” he predicted of the low cap rates.

Mr. Spier of Plaza Cos. said his firm markets both for-sale medical office condos and projects where physicians can buy a share of overall building ownership, but the firm is careful not to steer physicians toward one specific option. Physicians need to work with their business and financial advisors to make the best decision for their specific situation, he said.

“There’s a place for both, at least in our market,” he said.

 

The condo market could also cool as interest rates rise, the panelists said.

“Right now, we are starting to see a little bit of a slowdown,” Mr. Spier said. If interest rates rise to 8 percent, that could be the tipping point, he said. q

Next month we will provide additional coverage of the BOMA MOB conference, including highlights from a session on “Strategic Uses for Non-Acute Care Real Estate.”