Medical real estate is hot in California

INVESTORS PAY A PREMIUM FOR HEALTHCARE PROPERTIES IN THE GOLDEN STATE

By Jessica Griffith

 

California delivers 13 percent of the U.S. gross domestic product and would rank as the sixth largest economy in the world if it were a sovereign nation. Little wonder no other state has experienced as much growth in healthcare real estate during recent decades.

California’s demographic profile, economic history and unique regulatory environment contribute to an unusual real estate market, said Murray Wolf, publisher of Healthcare Real Estate Insights^™ during a recent Web-based seminar hosted by the publication.

The November seminar, also known as a Webinar, explored healthcare real estate in California from several perspectives.

Presenters were Robert Rosenthal, president of Pacific Medical Buildings in San Diego; Alan Pontius, senior vice president and national director of the Healthcare Real Estate Group at Marcus & Millichap in San Francisco; Joseph Euphrat, director of Shattuck Hammond Partners in San Francisco; and Philip J. “PJ” Camp, principal of Shattuck Hammond Partners.

All of the presenters acknowledged something called the “California premium,” meaning investors are willing to pay a preium and continue to be eager to own healthcare real estate in the nation’s most populous state. That’s because many investors consider California to be an established market with a low-risk profile.

At the same time, California can present unique challenges for developers introducing new facilities to the market, mainly due to the many regulatory challenges and the high costs.

By the numbers

An overview of the medical office market in California indicates why it is more attractive than other U.S. regions.

Vacancies in medical office buildings (MOBs) average about 9 percent nationwide, but in California the figure is closer to 6 percent, Mr. Pontius said during his presentation.

“Supply is low relative to demand,” he added. Of the major metropolitan areas, only San Jose has a higher vacancy and that is a comparatively small market where a single move by a medical group can significantly affect occupancy rates.

Rents in Los Angeles and the San Francisco Bay Area top $25 per square foot, on average; in San Diego and Orange County, the average rent is more than $30 per square foot.

Although development is on the rise, the new supply of space represents only 1.5 percent of the existing MOB stock, Mr. Pontius noted.

“When new supply is less than 2 percent of existing stock, that is perceived as relatively low and nowhere near enough to throw off the fundamental balance,” he says.

On the transaction side, the median price per square foot rose a whopping 80 percent from 2003 to 2006. Capitalization rates – a measure used to estimate an investors’ returns on a property —  also are dropping. Typically, as the overall risk of investing in a property decreases, investors are willing to accept lower cap rates.

“Trend lines and data make it quite evident California is a land unto itself,” Mr. Pontius says.

Go West, developers

 

A healthcare system or third-party developer that seeks to build new medical office space in California needs patience, a solid plan and perhaps a little gold-rush luck.

“The barriers to entry and to getting buildings built are enormous,” Mr. Rosenthal said. “It is more and more difficult to get projects up and running in California.”

New seismic requirements, along with industry costs, have dramatically increased the price per square foot for construction, the presenters noted.

For example, MOBs cost $200 per square foot to build in Northern California in 1991. By 2006, that figure jumped to $550 per square foot, according to Mr. Euphrat. He estimates building costs are 30 percent to 40 percent higher in California than in the rest of the country.

Construction costs have almost doubled in the past three years, Mr. Rosenthal added. In 2004, the average project cost per square foot was $166 and the required rent to support that price tag was $18 per square foot per year. Now, the cost is $300 per square foot and the required rent is $27 per square foot.

“The rents would have been higher but for lower interest rates and lower investor expectations,” he said. “But new buildings will be pulling existing building rents upward.”

Another challenge in California is the level of government intervention. Mr. Rosenthal cited several examples, from environmental concerns to traffic patterns. This makes projects more difficult to control, adds delays and raises development costs by about $9 per square foot, he said.

In addition, individual cities in California, even small ones, typically insist upon design control, according to Mr. Rosenthal.

“Virtually every city has a design review committee,” he said. “They are staffed by laymen and operate capriciously in some cases.”

Finally, developers must navigate the Office for Statewide Planning and Development, or OSHPD. Traditionally, MOBs did not require a state permit, but now smaller cities are referring more technical projects to the state. This adds time and complexity to a project. In some cases, permits are required for the tenant to receive Medicare reimbursements.

While government regulations impact some construction trends, others are driven by the demands of the healthcare market. Healthcare real estate must adapt in every region; California is no exception.

For one thing, MOBs are getting larger, Mr. Rosenthal said. Historically, MOBs were small and they still are, at least when compared to traditional office buildings. Even so, more and more MOBs are surpassing 200,000 square feet or larger.

Mr. Rosenthal cited two reasons for larger buildings. First, many medical groups are consolidating and thus require more space to house their doctors. Second, the proliferation of outpatient services means many of these MOBs are “full-blown hospitals without the beds.”

Advanced technology means MOBs often require sturdier floors to support sophisticated equipment. Also, data connections are needed to allow for electronic medical records.

Not quite green

Energy-efficiency is another important feature of MOBs.

“We don’t see any demands for green buildings,” Mr. Rosenthal said. “What we are seeing is the energy issue. Most leases are net leases and operating costs are passed on to tenants, so we have to find some way to reduce rents and operating costs are part of that.”

Another way tenants reduce costs is by leasing smaller spaces while spending more per square foot on improvements. Physician ownership or joint ventures with hospitals also can help offset costs.

Despite the difficulties, California remains a viable market for new MOBs, according to the presenters. The state experienced population growth of nearly half a million people per year from 2000 to 2005, resulting in demand for more than 1,100 new physicians.

Mr. Rosenthal said that figure translates into a need for 2.2 million square feet of new or remodeled medical office space.

“The population and demographic trends that exist in California are ample support for new supply,” Mr. Pontius said. The regulations and challenges of introducing new supply are risk factors, particularly if supply gets ahead of demand. But he noted that the market has demonstrated a clear need for additional space.

California is for investors

 

The balance of supply vs. demand in California is extremely attractive to landlords, Mr. Pontius added. Owning property in California is viewed as more secure compared with other regions of the country, and MOBs are increasingly popular with investors.

“The demand for healthcare real estate is very healthy in the institutional marketplace,” Mr. Euphrat noted.

 

Although health systems throughout the country are selling MOBs and other non-core real estate assets, the trend is particularly prominent in California. Hospitals need capital and they are looking outside the traditional trifecta of operating income, philanthropy and debt, Mr. Euphrat said.

In the first half of 2006, California MOB sales totaled $289 million, or 18 percent of the national volume, according to numbers from Shattuck Hammond Partners. In comparison, the entire Southeast region accounted for only 16 percent of the volume.

“There is a track record of increasing values in California and groups like to invest where they can see a track record,” Mr. Camp said. “With the sky-high values in California, it is time to consider monetizing.”

Monetization refers to the practice of selling MOBs and other non-core real estate to redeploy the cash to other hospital operations. (For a more detailed discussion of this trend, please see “Monetization momentum continues” in the November 2006 issue of HREI^™.)

“This is a time for active asset management, for hospital systems in particular,” Mr. Pontius added. “Real estate has to be examined to determine where it fits. It is not a time to sit still with business as usual.”

 

The California healthcare real estate seminar was the third in a series of four such Webinars presented in recent weeks by HREI^™ and its sister publication, HREI^™ Executive Briefing^™. Each Webinar covered a different topic, such as third-party development of medical facilities and physician investment in healthcare facilities.

A full 90-minute recording of each Webinar, complete with copies of all presentations and supporting materials, is available on CD-ROM. Please visit www.hreinsights.com for further details. q

Jessica Griffith is a business writer specializing in commercial real estate.