Roundtable discussion (December 2006)

2006: Sky-high pricing



By John Mugford


When an executive from a powerhouse real estate firm says the company is taking a bit of a breather from submitting competitive bids to acquire medical office properties, it’s a sure sign that the healthcare real estate market is in quite a different state than it was just a year or two ago.

And when executives from other major healthcare real estate firms echo similar sentiments with the executive, or at least empathize with him, that’s a strong confirmation that the medical real estate arena has changed drastically in recent years, including 2006.

Not only has the acquisition game changed – the result of increased competition, increased interest and an influx of institutional cash – but so has the business of developing medical properties.

No longer does a hospital ask for proposals from a couple of developers that it’s worked with in the past when looking to build a new medical office building (MOB). These days, hospitals are hiring consultants to make the whole development process more competitive. In the end, handfuls of developers, even some previously unknown to the client, typically submit bids to develop the MOB and, in effect, become a partner with the hospital.

These were a few of the many messages to emerge from a lively, wide-ranging roundtable discussion during a Healthcare Real Estate Insights Editorial Advisory Board meeting last month.

HREItook the opportunity to ask the board members, who are among the industry’s veterans and leaders, to discuss various topics reflective of what’s taking place in the industry.

The board is currently comprised of representatives of 12 companies heavily involved in healthcare real estate. Ten of those companies were represented at the editorial advisory board meeting, which was held in the offices of Ventas Inc. in Chicago. Raymond J. Lewis, senior vice president and chief investment officer for the firm, is a member of the board.

During the discussion, board members discussed current trends in the areas of healthcare real estate development, acquisitions, financing and other topics. Not only did they look back on 2006, but they put on their prognostication caps and looked forward to 2007 and beyond, commenting on where they believe the industry, and certain specific aspects of the industry, is headed.

The HREIstaff recorded the roundtable discussion and for this article we’ve chosen to focus on what the board members saw as emerging healthcare development trends in the past year. We’ll provide coverage of the other topics discussed, including what’s happening in acquisition, as well as future trends, in future articles – beginning with the January edition of HREI.

The executive alluded to at the outset of this article was Kevin O’Neil of Trammell Crow Co., who said his firm is not getting as involved in competitive bidding for MOBs as it once did.

“People have become very aggressive in the way they are pricing things and from our point of view medical office has become a tough deal to rationalize on the acquisition side,” he said. “So we’ve chosen not to be very aggressive. We don’t think this is a very good time to be buying, especially in a competitive RFP (request for proposals) environment. And that’s not to put the RFP process down, because that’s what a hospital needs to do to get maximum value.”

Mr. O’Neil added that the compression of cap rates has almost become “irrational.”

“Medical was out of favor at one time and now it’s become such a darling because everyone wants to put their money in some way, shape or form into healthcare,” he said. “It’ll be interesting to see how it plays out. We’re not saying the people making acquisitions are making bad decisions. We’re just saying we don’t know.”

Fred Farrar of Indianapolis-based Windrose Medical Properties Trust said that while there’s a lot more competition for MOBs right now, there’s also a lot more activity. He threw in a bit of a warning about the potential pitfalls of all the new competition.

“When you see more activity and more competition, including competition from less-experienced firms, then you’re probably going to see land mines down the road,” Mr. Farrar said. “To me it looks like the real estate professionals in this room are protecting themselves from getting into situations that have land mines down the road.”

As the board members discussed the historically high prices and low cap rates investors are willing to pay for MOBs, Glen T. Preston, the vice president of acquisitions for Nashville, Tenn.-based Health Care Properties Trust, offered an example.

“Speaking of competition,” he said. “I saw a deal in Phoenix last week, a one-off building that was priced below a 7.1 percent cap rate. In fact, it was in the mid-6s. Well, there were 25 bids for this property, which is a $14 million, maybe $15 million asset. That is just unbelievable.”

James M. Moloney of Cain Brothers & Co. added: “I saw that, too. The property had just been acquired six months earlier in a portfolio deal at about a 7.5 cap.”

When asked whether investors saw more opportunities in the last year, Mr. Preston noted that the “number of deals has skyrocketed.”

“I think we saw more of the one-off deals,” Mr. Moloney added, “but we’re starting to see some more big portfolios. I think that will be a trend for the year to come.”

Mr. Preston noted that the flow of MOBs being sold by hospital systems has been consistent over the past three or four years as has been the flow of larger, $100 million-plus deals.

“We’re typically seeing a couple of larger portfolio deals in the $100 million to $200 million range, then a couple of deals in the $50 million range, down to $25 million,” he said. “But most of the activity of late has been from individual investors selling their one-offs.”

Board members also said all of the competition has led to more consolidations and mergers in the industry. “When I look around this room I see several people whose companies have been involved in consolidations,” Mr. Preston said.

Mr. O’Neil added that some acquisition deals have become so complex that they can cause “brain damage.”

“Sometimes it’s easier to just go out and buy a half-billion dollar company and get the assets along with the deal instead of trying to slug it out in the RFP process,” Mr. O’Neil said. “Not that there’s anything easy about buying a company, but if it’s just as complex as buying a portfolio, why not?”

Board members discussed whether MOB pricing will drift back to some sort of normalcy anytime soon. They said they’ve heard of sales in which buyers are acquiring older, Class B buildings with plenty of vacancies and still paying premiums, including low cap rates.

“The pricing umbrella keeps stepping up with replacement costs,” said Mr. Moloney. “If you look at a market like Phoenix and you have a B-plus building there you’re still going to be able to charge big rent increases because the campus the building is on, or next to, is full and the only building with available space is a new Class A building at the current high replacement costs. Scenarios like that pull rates up in all buildings.”

Another board member asked whether hospitals will raise concerns when their doctors complain about higher rents.

Mr. Moloney answered: “We’re in a 20-year cycle where there was inefficient ownership years ago. Now, we’re moving to a much more institutional approach to rents and hospitals will not care if their doctors squawk when everyone is paying market rates. They do care when the building next door is doing deals below market and their own doctors are paying market. I think it will take the next 10 to 15 years for all markets to become institutionalized, but it is going to happen eventually.”

Jonathan Winer of the New York office of Ernst & Young added that because there’s so much capital in the market, including that from large institutions, pricing is likely to keep rising. q

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