WRIT combines focus and diversification

WASHINGTON REIT HAS AMASSED PERHAPS THE TOP MOB PORTFOLIO IN THE D.C. AREA

 

By Dan Emerson

 

Earlier this year, an acquisition of four medical office buildings in Maryland by Rockville, Md.-based Washington Real Estate Investment Trust (WRIT) caught the eye of market observers.

The acquisition was noteworthy because the four-building portfolio carried an average cap rate of 5.9 percent – even in today’s high-demand, low-cap rate market, the deal was considered by many to be an indication of how intense the demand for medical office buildings (MOBs) has become.

Three of the MOBs, with a total of 141,858 square feet, are located in close proximity to each other in Rockville, Md., within a quarter-mile of Shady Grove Adventist Hospital. The fourth, with 33,341 square feet, is located in Bel Air, Md., within a mile of the Upper Chesapeake Medical Center, an acute-care facility that opened in 2000.

At the time of acquisition, WRIT expected the portfolio to produce a first-year unleveraged yield of 6.6 percent on a GAAP basis and 6.3 percent on a cash basis. The company assumed three mortgages in the amount of $19.4 million bearing interest at a weighted average interest rate of 5.4 percent, with the remainder to be funded through its line of credit.

Even though some observers might consider the cap rates – which range from 5.75 percent to 6 percent on each of the buildings – to be too low to be considered a worthwhile investment, other factors made the MOB portfolio a very safe investment indeed, according to Ed Cronin, Washington REIT’s CEO.

For example, the portfolio’s occupancy is at or near 100 percent; the MOBs are in close proximity to acute-care hospitals; and, in general, MOBs provide long-term stability, which in turn is making them the highly sought-after investments they have become.

Bullish on MOBs

Founded in 1960, Washington REIT has assembled a portfolio of 82 income-producing properties in the greater Washington/Baltimore metro region. It owns 14 retail centers, 24 office properties, 13 medical office properties, 22 industrial/flex properties, nine multi-family properties, and land for redevelopment.

While WRIT did not acquire its first medical office property until 1998, it now possesses what some observers consider to be the top MOB portfolio in the Greater Washington market. Even though WRIT had entered the medical office arena in the late 1990s, it didn’t focus on the sector until early 2001 – a time when the “general office market became weaker,” Mr. Cronin says.

Mr. Cronin had gained a familiarity with the sector while spending time on the finance committee of the board of directors at MedStar Health, a Baltimore-based not-for-profit system. For the past four years, Mr. Cronin has served as chairman of the board of Georgetown University Hospital.

With a more intense focus on the MOB sector to begin the new millennium, WRIT stepped up its MOB acquisitions beginning in 2003.

In fact, in addition to the portfolio acquisition in Rockville and Bel Aire earlier this year, WRIT’s 2006 acquisitions have included:

■ Alexandria (Va.) Professional Center, a 12-story MOB with 113,048 square feet. WRIT anticipated a first-year unleveraged yield of 8.2 percent on a GAAP basis and 7.6 percent on a cash basis. Located within a half-mile of Inova Alexandria Hospital, the property is 100 percent occupied with 36 tenants, primarily small-tenant medical office users. The property is one of few pure medical office properties in the Alexandria sub-market, which WRIT officials say enhances its value.

■ The Ridges, a three-story MOB in Gaithersburg (Montgomery County, Va.). The property is located near several of the area’s largest hospitals. WRIT also acquired two other general office properties in Montgomery County: The four-building, 289,491 square foot West Gude Office Park; and The Crescent, comprised of two single-story office buildings totaling 152,976 square feet.

Montgomery County has a rapidly growing population, and WRIT expects to achieve a first-year, unleveraged yield of 6.6 percent on a cash basis, 7.1 percent on a GAAP basis. WRIT assumed two loans totaling $57.3 million at a weighted average interest rate of 5.84 percent. The remaining $36.7 million will be funded through its line of credit.

Caps low, optimism high

These days, WRIT typically acquires MOBs for an average cap rate of around 6.4 percent to 6.5 percent, Mr. Cronin says. He also notes that “when we quote cap rates, that includes all closing costs in addition to transfer taxes, and legal costs.

“The cap rates will vary depending on proximity to acute-care hospitals, availability of nearby developable ground, age of the buildings, and, not least of all, buildings built as MOBs with wide hallways, gurney-sized elevators and necessary utility capacity to meet various users’ needs,” Mr. Cronin adds. “As a long-term buy and hold REIT, we expect through the built-in annual escalations and our managing and leasing expertise to continue increasing the NOI. Unlike the general-purpose office sector, the MOB (sector) is generally less affected by market conditions.”

Lower cap rates represent a recent trend in the MOB sector, according to Scott Sedlak, an analyst with A.G. Edwards & Sons. He says the medical office sector has become more competitive in recent years as more investors have become aware of the advantages of owning MOBs. This, in turn, has led to lower cap rates and higher prices, with most indices pointing to average sale prices per square foot (PSF) topping $200.

“There’s clearly been a lot of interest by investors in this product type over the last several years,” Mr. Sedlak says. “When there wasn’t as much interest in owning medical office buildings, cap rates were higher. But we’ve seen cap rates compressed from 8 to 10 percent a couple of years ago, to below 7 percent for many MOB properties.”

A disciplined approach

When it goes looking for MOBs to acquire, WRIT only considers properties that were built specifically for medical purposes, according to Mr. Cronin. Such buildings must also be located near, or within a few minutes of, major acute-care hospitals before WRIT will take a closer look.

“Location is really critical, even more so than with other types of real estate,” Mr. Cronin notes.

“We choose MOBs that are near acute-care hospitals in areas where doctors are no more than a five minute drive from their homes to their offices and hospitals and, possibly, their country clubs,” he jokes. “Physician time is so limited, they need to be very efficient in their movements.”

One of the advantages to owning medical office properties is that once physicians choose the MOB for their practices, they typically stay put for a long time.

“I compare MOBs to neighborhood shopping centers – they’re well-anchored with stable, long-term tenants,” Mr. Cronin explains. “One difference is that when you have a shopping center, the major tenants don’t have any major escalation in their rents over the holding period; it’s almost like being partners in the deal.”

In contrast, “in medical office buildings, everyone is paying market-rate.”

Mr. Cronin adds: “Our experience has been that within the first year we’ve been able to pick up another 50 to 60 basis points and after the first year, depending on rollover, 150 to 200 basis points per year” as rents escalate over time to keep pace with market rates.

When WRIT acquires an MOB, tenants typically have from three to seven years left on their leases, with 10 years being the most typical term in the MOB sector, according to Mr. Cronin. While WRIT has developed some industrial, office and retail projects over the years, it has yet to develop its own MOB.

“We treat MOBs as a separate sector from general-purpose office buildings,” Mr. Cronin says, noting that there are certain barriers to entry that are unique to the MOB sector. Such barriers can certainly be a positive for the owner of an MOB in the right location.

“With MOBs, in most instances, there is no other land in the area convenient to hospital locations on which to build competitive medical office buildings,” he says. “And, by nature, medical office buildings are limited in how large they can be. So unlike general office buildings, they’re not exposed to a marketplace where someone can come along and build a bigger, better ‘mousetrap.’”

Another factor WRIT uses to offset today’s low cap rates is its experience in the business, Mr. Cronin says. His firm’s 40-plus years of experience and close proximity to its properties, as well as its own in-house property management and leasing teams, makes it “very good at property management and leasing within that portfolio. We can manage them much more efficiently than most people – we have done some analyses based on operating expenses and, compared to other owners, we are able to operate MOBs for 3 to 5 percent less expensively per square foot.”

“Most of the buildings we’ve acquired,” Mr. Cronin continues, “with the exception of one, have been newer; and we’re very focused on keeping properties in top-quality condition. Every MOB property we’ve acquired has needed some capital investment to satisfy our own requirements.”

But those required improvements have typically been relatively minor, he notes. “If it’s an older building, it might require a new roof.”

Off their hands

Like many other firms looking to acquire and manage MOBs, WRIT says it can provide a service to a health system looking to monetize its ancillary real estate.

Mr. Cronin says many health systems are beginning to realize that having landlord-tenant relationships with physicians can lead to potential negative experiences and can, potentially, sever ties between a physician and a hospital.

“They look to various medical practices to provide patients for the hospital,” Mr. Cronin says. “In the meantime, it can become sort of an adversarial relationship if doctors are leasing from them. If they get in disputes with doctors who are providing services, that could impair what the hospital’s basic business is all about.”

WRIT’s experience with physician tenants has been positive, he adds.

“We have found doctors to be fairly easy to work with,” Mr. Cronin says. “They are no different from anybody else when it comes to negotiating a lease. Once a lease has been signed, they are no different from any other tenant, as long as you provide the services they need and run a good building.”

Geographically focused

As far as WRIT is concerned, doing business in the Washington, D.C., area is like working in the backyard. Mr. Cronin points out that an advantage to WRIT’s geographic focus – which actually spans from Richmond, Va., to Philadelphia — has been its ability to form and maintain long-term business relationships with local real-estate developers.

“They know us and know that we’re not the type of company that will come in and try to redo a deal after we have agreed to a price,” he says. “Unless we find something significant in our initial underwriting and due diligence, we are not going to come back and try to modify the purchase agreement.”

When all property types are included, the Washington Consolidated Metropolitan Services Area (CSMA) ranks as the top national and international real estate investment market, according to the 2004 Association of Foreign Investment in Real Estate (AFIRE) survey.

It leads all metro areas in the nation in employment growth over the past 20 years, represents the fourth-largest metro economy in the United States, has the number two media income of any large metro region in the country, and has the lowest unemployment rate.

“There are 51 hospitals in the Baltimore-D.C.-Richmond (Va.) region, so there is a lot of opportunity in this market,” adds Cronin, who joined WRIT in 1994. “MOBs are such good investments; none of those we’ve acquired were owned by institutions; they were owned by individuals. They are very nice assets to hold, so it can be like pulling teeth to convince some owners to sell. But we are interested in continuing to build our MOB platform. We have a very balanced portfolio from each sector.”

While MOBs currently generate about 11 percent of WRIT’s net operating income (NOI), Mr. Cronin says that the company has plans to increase that amount in the future. And even though WRIT is geographically focused, he adds: “If there is an attractive out of market portfolio opportunity, with some concentration of MOB product, we will give it serious consideration.”

A unique blend

Because of its geographic focus and diversified portfolio of properties, WRIT has a singular niche among the country’s REITs, according to Charles Place, an analyst with Baltimore-based Ferris, Baker Watts, Inc.

“WRIT is unique in that they are diversified by property-type and focus exclusively on investing in the Washington, D.C., market,” he says. “There are several other REITs that have a geographic focus, or have a diversified portfolio across property types, but not both.

“The WRIT management team, led by Ed Cronin, has significant experience in the D.C. market and has developed strong relationships with property owners in the region,” Mr. Place adds. “Demand for MOB properties is strong, and pricing for these assets is very competitive. But WRIT has been successful in acquiring MOBs because they are contacting owners directly and negotiating off-market deals, meaning that in most cases, these properties are not offered to the market for a competitive bid auction.”

MOBs are attractive assets when compared to standard office properties, according to Mr. Place. That’s because the MOB tenant base is viewed as more stable, especially for those properties that are located on or near hospital facilities and in areas where there is no logical or easy land-development opportunity.”

In its recent third-quarter earnings report, WRIT reported that its MOB portfolio has an occupancy rate of 99 percent with minimal lease rollovers. It reports that it leased 47,000 square feet during the third quarter of this year.

“The strategic location of our properties, combined with excellent market conditions, contributed to outstanding results this quarter.” Rental rates increased 25 percent on a GAAP basis and 8.9 percent on a cash basis, the firm reported. q

Dan Emerson is a business writer who often reports on healthcare real estate.

FACT BOX:

STATS

■ Revenues: $190 million in 2005; $160.2 million YTD 2006 (as of September)

■ Employees:  273

■ Real Estate: 11.8 million square feet in 14 retail centers, 24 general office properties, 13 MOBs (874,000 square feet), 22 industrial/flex properties, and nine multifamily properties

■ Ownership:  Public. As of March 16, 2006, trustees and officers owned 1.87 percent of total shares; T. Rowe Price owned 7.90 percent of total shares

■ History: Founded in 1960; went public in 1961

■ Services provided: Develop, design, construct, lease and manage properties

CONTACTS

■ Key officers: Edmund Cronin, chairman and CEO; Sara Grootwassink, CFO

■ Main phone: (800) 565-9748

■ Web site: www.writ.com