Why develop non-acute care real estate?

BOMA MOB CONFERENCE DELVES INTO THE STATEGIES BEHIND OUTPATIENT FACILITIES

 

By Murray W. Wolf

 

At first glance, the impetus for developing new outpatient facilities can seem as simple as a need for more space. But upon closer examination, there are usually myriad other reasons – many of them strategic.

Those issues were discussed during the June 22-23 “2006 Medical Office Building and Healthcare Facilities Seminar” in Dallas. The two-day event was sponsored by BOMA International. The title of the panel discussion was “Strategic Uses for Non-Acute Care Real Estate.”

The moderator of the panel was Jonathan “John” Winer, managing director for the Transaction Real Estate Advisory Services Group of Ernst & Young in New York.

The panel consisted of:

• § Malcolm Sina, president and CEO of DASCO Cos. of Palm Beach Gardens, Fla. DASCO, an affiliate of CNL Retirement Properties, is a medical real estate firm providing development, acquisition, leasing, marketing, project management and property management services.

 

• § Chuck A. “Chuck” Elcan, executive vice president of medical office properties for Health Care Property Investors Inc. (NYSE: HCP) in Nashville, Tenn. Long Beach, Calif.-based HCP is the nation’s largest healthcare real estate investment trust (REIT).

 

• § Neil Carolan, network vice president – physician development and integration for Carondelet Health Network in Tucson, Ariz. Carondelet is a Catholic, not-for-profit healthcare system with three hospitals, two medical malls, two imaging centers and a medical group with 14 other locations in southern Arizona. It is also recently announced plans to buy a fourth hospital and has acquired land to build a fifth.

 

• § Todd Maxwell, director of property management for HCA Inc. (NYSE: HCA) in Nashville. HCA is the nation’s largest for-profit hospital operating company. The firm established a non-hospital-based outpatient services group in 2003.

 

• § Craig T. Beam, West Coast regional partner with Hammes Co. in Orange, Calif. Hammes Co. is a Brookfield (Milwaukee), Wis.-based healthcare real estate firm providing strategic planning, development, acquisition, leasing, marketing, project management and property management services.

 

MOBs are evolving

Mr. Winer launched the discussion by describing how the role of the most prominent of outpatient facilities – the medical office building (MOB) – has changed in recent years.

“The medical office building has now become a strategic asset, helping (health systems) to achieve their goals,” he said. In just the past year, he said, Ernst & Young has consulted with hospital and health system clients regarding on- and off-campus MOB projects that have included ambulatory surgery centers (ASCs), imaging centers, labs and more – many structured as joint ventures (JVs) with physician tenants.

“So that’s a pretty broad range of uses that all come under the medical office building banner,” he said.

Turning to the panelists, Mr. Winer asked: “How can hospitals leverage non-acute care real estate to drive their business strategies?”

Mr. Sina of DASCO replied: “A lot of what we see today in terms of what we’re developing, what we’re acquiring, primarily is for a lot of fundamental reasons … hospitals not wanting to use their own capital.”

Real estate isn’t a core competency for most hospitals and health systems, he explained. Using other people’s money enables providers to expand outpatient services and to create more patient- and physician-friendly facilities while focusing on their core mission of delivering healthcare services. Providers can maintain control over third-party owned facilities through control provisions in ground leases.

“I think the trend will continue,” Mr. Sina said. “Certainly there are some accounting challenges that are being interpreted today … but we certainly see that trend continuing,” both on and off campus.

Many providers are using off-campus facilities to expand and brand their services in fast-growing, higher-income areas, he said.

Mr. Elcan of HCP said outpatient real estate joint ventures also help with physician recruitment and retention.

Mr. Carolan of Carondelet added: “I also have a fundamental belief that hospitals don’t do a good job and shouldn’t own – other than hospital buildings – any other property because they don’t do a good job at it.” But he cautioned that “there has to be a synergy between the developer and the healthcare system.”

‘Old buildings, old nuns’

Mr. Carolan said that Carondelet conducted a survey four years ago and found that the system was equated with “old buildings and old nuns, and that was exactly the way it was.” But the system has significantly upgraded and expanded its facilities during the past three years, he said.

One of Carondelet’s strategies has been to develop medical malls, he said. The facilities are about 30,000 square feet in size and are staffed by primary care physicians. They also include imaging and lab capabilities – “great revenue streams for us. And then we take part of that space that we master lease from the developer and time-share it to the specialists.”

Carondelet management believes that it’s important for specialists to “get out into the community,” Mr. Carolan said. “Patients want them closer to home.” He said the specialists might spend a half a day or a day per week at the medical malls. It’s important for specialists to interact with primary care physicians because they are the primary source of their referrals.

Establishing outpatient outposts also enables patients to avoid traveling “all the way to Tucson,” he said.

“As we take a look at how we’re delivering healthcare, we also have to understand that especially an aging population like Tucson, getting that healthcare as close to the patient or the consumer is also very important,” he said.

Mr. Maxwell of HCA said site selection is such a key element of the outpatient development program that the firm’s real estate team “actually reports up through this new (outpatient) operating group.”

Mr. Beal said Hammes Co. is seeing the same outpatient development trends. But in California, where he is based and where real estate costs are well above the national average, he said that leveraging capital is especially important.

“Anything that can be moved out of a $550 a square foot building is being moved out of that building and being put into a lower-cost setting,” he said.

Dealing with docs

Mr. Winer asked how the move toward third-party development and ownership of outpatient facilities has affected relationships between hospitals and physicians.

“I think initially it caused some conflict,” Mr. Carolan of Carondelet said. “Doctors like to rent from hospitals because they don’t have as good of an understanding of Stark and going to prison as we do.” (The Stark and anti-kickback laws are civil and criminal statutes that prohibit physicians from referring patients to a facility in which they have a financial interest, or for getting paid to make referrals.)

In the past, when hospitals owned MOBs, they would frequently lease space to physicians at less than market rate rents. With third-party ownership, physician-tenants nowadays must pay market rate rents. Although doctors might not be thrilled with the new laws, Mr. Carolan said, there are ways to soften the blow.

“The quid pro quo for us has been that we’ve offered them some joint venture opportunities,” he said. The hospital has developed two freestanding ASCs, and it owns the operating businesses – though not the real estate – in partnership with physicians. After positive experiences with those ASC ventures, he said the physicians now want to partner on imaging and other services.

Offering a word of advice to hospital and health system executives in the audience, Mr. Carolan added: “And you never sell the land. Always keep the land, hospitals … but don’t build the buildings.”

“When we first started our property management program it was very unpopular” with both physicians and hospital CEOs, Mr. Maxwell of HCA said. “But as we’ve gone through a long and painful education process, a lot of them get it now. They do understand and they are enjoying the opportunity to syndicate on the ASCs in partnership with developers.” He said HCA does not offer operating partnerships, but it does permit physicians to have real estate partnerships with third parties.

“Physicians do want those opportunities and we offer them the best way that we can,” he said.

The other big advantage of third-party ownership is that the hospitals are no longer responsible for property management, Mr. Carolan added.

The doctor is out

Mr. Winer asked how the trend toward outpatient care is affecting MOBs.

“It’s having a tremendous effect,” Mr. Beal of Hammes Cos. said. “Sixty-seven percent of all surgeries are now done on an outpatient basis…. So it’s a huge transition.” That means MOBs need to designed and built with emergency generators, higher-capacity air handling equipment, higher floor-to-ceiling heights and other features.

“So it does have a cost impact in terms of the design of a building,” he said.

Mr. Winer asked if those added costs increase rents for all tenants.

“You need to be careful because the docs who are going to be renting in the building really are very sensitive to including any of the inpatient costs in their outpatient rent,” Mr. Sina of DASCO said. So, if an ASC requires additional design and construction features, he said his firm makes sure that it separates those additional costs and adjusts rental rates accordingly.

“That way it provides a much more competitive rental rate to the physicians,” he said.

Mr. Sina said that the shift to outpatient care is only going to continue. Inpatient services spending during the past four years has grown by only about 3.5 percent, he said, compared with more than 12 percent per year for outpatient.

Mr. Beal noted that proposed changes in government reimbursement rates would provide another incentive to deliver healthcare services on an outpatient basis.

Mr. Winer noted that MOB costs are rising, but he said that outpatient space us still a lot less expensive than inpatient space.

“It’s probably a difference of $600 versus $150 to $200 per square foot,” Mr. Sina said.

Mr. Winer asked why MOB development continues to increase.

“Part of that answer is cost,” Mr. Elcan of HCP said, adding that MOBs can be built for $200 per square foot or less, depending on the market.

“I think that’s one of the reasons we’re seeing a lot of this growth in medical office buildings and moving out of the hospital settings. And another reason is a lot of these hospitals are just maxed out. They don’t have any more room in the hospital itself to add additional services.” he said.

“I think another big reason for all of that is recruitment,” Mr. Carolan said. “If you’re trying to grow medical staff, you want young, well-trained, bright men and women. And they want a nice place to practice.”

He continued: “Not only do they want a nice place to practice, they also want some skin in the game.”

“Another part is functional obsolescence,” Mr. Beal said. Many older MOBs were designed with very narrow floor plates for solo practitioners. As medical practices get bigger, those floor plates don’t work anymore. So those buildings are being torn down to make room for more current designs, he said.

Other reasons for the surge in MOB development include a desire by hospitals to extend their brands to growing suburban areas and better management, which has made hospitals more profitable. Better management also provides hospitals the capital they need for development projects.

Help with decision making

“I think what most healthcare systems need is they need help with decision making,” Mr. Winer said. He said the health system executives don’t always understand how real estate fits into their overall strategy. They also tend to lack familiarity with the healthcare real estate development community, so they’re not sure which third-party developer or investor to select, he added.

Ernst & Young looks at project feasibility and helps providers to determine which firm to select, he said, adding that there are now plenty of qualified MOB developers.

“One hurdle you always need to get over is you don’t just want to go to the local person in town who has never built a medical office building. You really need to go to a firm that does this for a living,” Mr. Winer said.

“There are certain hospitals or certain systems out there that really don’t understand what they already own or what they have,” Mr. Elcan said. He said HCP’s first step is to compile an accurate list of the hospitals’ assets, then to consider which services could be moved out of an acute care setting.

“So the education process is really critical” he said. “And some of these larger not-for-profits that have been around for 80 years plus – some of them don’t understand what they own today. You almost have to go to the tax rolls to really find out what they do own and what they don’t own. And they can have land, parking lots, houses … and they don’t even know about it.”

Risky business

Mr. Winer said that another part of his firm’s job is to help providers to evaluate the potential for off-campus facilities.

“When you start going out into the community, it raises the level of risk and therefore raises the level of expertise you need in order to make sure you execute the project correctly,” he said. “Clearly, there’s a value add for a firm that can help a health system understand opportunities that are available by moving facilities off campus.”

“That hospital real estate is so darn expensive,” said Mr. Carolan of Carondelet. “We need to get as much out of the hospital as we can to maximize that bed utilization. Because I think that we’re looking at everything – every opportunity that we have.

“So we’re getting all of the nonessentials – including administrative – and freeing up as much space as we can.”

He continued: “We were better off going out and buying an office building, getting somebody to manage it for us and moving (all non-acute care services) out of the hospital.”

Mr. Maxwell of HCA added: “We see it a lot in the amount of administrative and other non-strategic uses that have been offloaded to the MOBs or to other locations to be able to redeploy that actual hospital space for higher or better use.

“It’s probably done with us more on the regional level. Each division is responsible for kind of figuring out their best game plan for their group of hospitals. It’s certainly looked at in lots of different ways.”

Mr. Winer said that Ernst & Young is currently working with a system that was the product of some mergers and which had about 50 off-campus locations. The system’s original assignment was for Ernst & Young to help it to consolidate those locations, he said. But the strategy quickly became more sophisticated, involving branding and new MOB development as well as consolidation.

How much office?

In response to questions from the audience, the panelists said that ASCs can range from about 8,000 square feet to about 30,000 square feet, that covered parking is a big selling point when trying to attract physicians to a building, and that a 3:1 or 4:1 ratio of physician office space to outpatient services space is about right. Mr. Sina said that a building can have less office space if the site allows for future expansion.

“There’s always a blend of how much additional space that you build because of the concern on the developers’ part to be able to lease up all the space,” he said.

Mr. Winer asked if the developer’s risk differs for on-campus projects versus those built off campus.

“I think on-campus is a safer bet, in general,” Mr. Beal of Hammes Co. said. “And partly that relates to the off-campus strategies.” If you can employ the doctors, that reduces the risk, he said.

“In a market like Texas or California, where hospitals cannot employ the doctors, then it’s a significantly higher risk,” he said.

“The more interesting phenomenon that’s occurring right now is some traditional commercial developers are entering the market by building slightly off campus and not bearing the burdens” that hospitals and traditional medical office developers do, he said.

“We typically work with the hospital and that’s how we mitigate the risk,” whether it’s on or off campus, Mr. Beal said. He said it’s more risky to go off campus without the hospital as a sponsor or a quasi sponsor. Even so, he said he’s starting to see more unaffiliated MOB development.

“We’re starting to see more of that now because, frankly, from a developer’s standpoint, working with the hospitals… there’s some brain damage involved in that process in terms of negotiating ground leases and negotiating restrictions we have to live with,” he said. But those headaches are offset by the reduced risk, he said.

“We always – and probably always will – be an advocate and partner with the acute care hospital, Mr. Sina said. “We’re really not that interested in partnering solely with physicians. So, when we’re doing any building off campus, we really want … the anchor. We want a reason to be able to draw patients and physicians to be there.

“We just don’t want to be the typically suburban building … where you have to sell a green building is better than a blue building across the street. We want that branding. We want the anchor tenant in there. We want there to be a long-term reason for those physicians and for those patients to locate there.

“Without that, we’re really not interested in doing the project.”

“We want everything that Malcolm wants,” Mr. Elcan said. “But we’re also willing to step out with an anchor group of physicians and create a surgery center or whatever operations entity it may be.”

Why go outpatient?

Part of HCA’s recent focus on outpatient facilities results from a desire to enter growing markets ahead of the competition, Mr. Maxwell said.

“The fact that we’re already there could discourage or prevent … someone else from coming into our backyard,” he said.

“We can use these locations as feeders back to our primary hospital,” he added. “We have a lot of capital invested there. We’re not going to abandon that.”

Outpatient facilities also enable HCA to extend its brand and to provide services to “smaller markets that maybe we didn’t feel could support services previously.”

Mr. Carolan cautioned that ASCs could get overbuilt.

“At some point we’re going to max that out,” he said. He said Carondelet emphasizes primary care not ASCs.

“Primary care is still the core foundation for any hospital’s success because those primary care physicians feed the specialists,” he said.

“It’s not as flashy, maybe,” he continued. “But an old friend of mine in Houston taught me a long time ago: The hospital with the most doctors wins. That’s really what it’s about.”

An audience member asked how far a freestanding outpatient facility should be from an acute-care campus. The panelists agreed that there is no reliable rule of thumb; the answer depends on a variety of factors including service area, demographics, competition and whether the facility is affiliated with a hospital.

“I don’t think there’s an easy answer,” Mr. Beal said. “I think each one’s almost an individual response based on those market conditions.”

“It also depends whether you’re hooking up with a hospital or not,” Mr. Elcan said. “You could have a group of physicians going out on their own that don’t have a hospital relationship. So then it’s all demographic driven.”

Developer’s to-do list

Mr. Winer asked what developers can do to bring value to outpatient projects.

Mr. Carolan said they can bring experience, design expertise, and marketing and leasing capabilities – “all the stuff that … hospitals are really bad at.”

The sophistication of MOB developers is growing, he continued, and it’s extremely difficult to select a developer from a request for proposals (RFP) process.

Developers also bring value because they can offer equity participation, ownership and creative financing models that HCA as the provider can’t offer due to Stark and other issues, Mr. Maxwell said. “And when the doctors do want that, that’s a very good selling point.”

“I don’t think we’ve worked on a project in the past couple of years where there hasn’t been an equity component of some sort offered to the physicians,” Mr. Winer said. “And the interesting thing about it is that there either tends to be a tremendous amount of interest or no interest. But still from a standpoint of it attracting the attention of physicians, in all cases, it seems to work well.”

“Sometimes there’s a tremendous amount of interest, but it never gets followed through,” Mr. Elcan said. “Our experience is about 20 percent of them follow through.”

“I think from a marketing standpoint, physicians like to know that that’s available to them, whether they actually do it or not,” Mr. Winer said.

“All the physicians today are looking for additional sources of revenue,” Mr. Sina observed, whether it’s a joint venture, real estate or whatever.

In structuring these transactions, Mr. Winer cautioned that hospitals need to keep in mind that “it needs to be a quality opportunity because if they structure something, the doctors invest and later it doesn’t work out well, unfortunately, what typically happens is some of that blame will land on the doorstep of the system.”

He added: “You need to be structuring smart transactions on behalf of your physicians and if you do that, then you have a successful deal.”

How to assess demand

“It seems most health systems that we talk to have no idea if there’s really demand or not,” Mr. Winer said. “They just want a new medical office building.” He asked how, then, developers go about assessing demand.

Mr. Sina said DASCO starts with industry standards for the number of physicians required to serve a given population. Then it modifies those calculations in light of local demographics, primarily age.

He noted that some developers distribute vague surveys, asking physicians if they might be interested in a new MOB.

“Physicians are by nature intrigued about anything new. So typically they’ll say, ‘Absolutely, I’m interested,’” he said. Then the developer will use that supposed demand to convince the hospital to sign a master lease.

A much more realistic gauge of physician interest is to go to them with actual lease rates and deal structures, Mr. Sina said. To accomplish that, DASCO does a preliminary site plan, schematic and design, and then obtains estimated construction costs from local contractors. At that point it can approach physicians with more meaningful numbers, he said.

Mr. Beal said Hammes Co. shares that philosophy. He added that, if physician recruitment is a goal, his firm also makes sure the hospital understands that there will be costs beyond the real estate. Recruiting can cost as high as $350,000 per physician in some parts of the country, he said.

Parking can be another unanticipated cost, Mr. Beal said: “Typically the biggest challenge today” is parking. He said that the analysis for on-campus MOB projects often suggests the need for a parking structure “and the economics around the parking structure are probably the biggest killer of most of these concepts today.” q

Next month we will provide additional coverage of the BOMA MOB conference, including highlights from a session on “Creative Marketing Strategies.”