LTACs, high-acuity MOBs on the radar

HREI^™ EDITORIAL BOARD MEMBERS TALK ABOUT EMERGING DEVELOPMENT TRENDS

 

By John Mugford

 

Healthcare development is an ever-evolving, ever-changing game of trying to pinpoint what health systems, physicians and, especially, patients want in their medical facilities.

At a recent meeting of the Healthcare Real Estate Insights^™ Editorial Advisory Board in Chicago, board members – who can certainly be considered among the leaders in the industry – were asked to reflect on recent and future trends in the healthcare real estate industry.

With a fabulous view of the Chicago skyline from the offices of Ventas Inc. (NYSE: VTR), which hosted the meeting, board members discussed a variety of topics, including acquisition and development trends in 2006 and coming trends for 2007 and beyond.

The discussion concerning acquisition trends was detailed in last month’s edition of HREI^™. (Please see “2006 legacy: High prices” on Page 1 of the December edition.) This month, we share the group’s insights into development.

Last year, board members said they witnessed an increase in the development of long-term acute-care (LTAC) hospitals, a surprising re-emergence of interest in medical office condos, continuing interest in physician ownership of medical office buildings (MOBs), and an increase in MOBs offering some acute-care services.

In fact, when the board was asked about new development trends in 2006, one board member noted that the building of freestanding “LTACs came out of the woodwork” in the last year or so. They emerged mainly because of reimbursement restrictions placed on hospitals within hospitals, thereby forcing operators to build new facilities detached from hospitals, according to board members.

“There’s still plenty of volume of new MOB developments,” said Raymond J. Lewis, senior vice president and chief investment officer of Ventas, a healthcare real estate investment trust (REIT) that has concentrated on senior facilities in the past but is now looking to diversify with MOBs and other medical property types.

“But if you look at acceleration of interest and volume, that’s where… LTACs came out of the woodwork.”

Because the changes in reimbursements are driving the development of new freestanding LTACs, the trend should continue, according to the board members.

However, board members added that there is a potential caveat: The Center for Medicare and Medicaid (CMS) might, at some point, consider making further changes in reimbursement policies for LTACs.

“The continuing development of LTACs might depend on how long the dollars continue to flow,” added Mr. Lewis. “I do think CMS has LTACs on their radar screen because the growth projections for LTACs has raised the attention of CMS. We’ve already seen – with the first round of proposed changes in January of last year that were implemented in May – where CMS proposed the elimination of the short-stay outliers. That was the first shot and I don’t think the government is done with LTACs just yet.”

Ever-changing MOBs

As the discussion moved to MOBs, James M. Moloney, as senior vice president with the  San Francisco office of investment bank Cain Brothers & Co., said he’s seeing an increase in the amount of acute-care services being offered in medical offices.

“I think that’s off-balance sheet, off-campus, and also on-campus,” Mr. Moloney said. “You’re seeing medical office buildings built sometimes in the basement of a hospital, or on the top of a hospital, when space is tight. We’re actually seeing an increase in short-stay hospital presence in medical office buildings. A couple of years ago the trend in medical office development was to put in a big ambulatory surgery center. Now you’re seeing a 10-bed short-stay hospital in medical office buildings.”

Mr. Lewis of Ventas noted that such a scenario indicates that in today’s world of healthcare, it is not easy to precisely define an MOB. “The lines between what constitutes a medical office building and a specialty hospital are starting to blur.”

Jonathan L. Winer, a partner with the Real Estate Advisory Services unit of New York-based Ernst & Young, said that adding more services to MOBs, including acute-care type of services, is being driven by skyrocketing construction costs of hospitals.

“It’s become so expensive to build hospitals now that anything that can be done outside of the hospital will be pushed outside of the hospital – at least they’ll try as hard as they can to do so,” Mr. Winer said.

Board members, however, noted that the development of such facilities is usually limited to states with fewer health facility restrictions. For example, it is likely to be difficult, if not impossible, to add beds to an MOB in states with Certificate of Need (CON) laws.

Fred Farrar, president and chief operating officer of the recently acquired Windrose Medical Properties division of Toledo, Ohio-based Health Care REIT (NYSE: HCN), said: “It’s a total outreach approach to the market, including both inpatient and outpatient services.

“What really is a hospital campus anymore? The large urban campus that’s been added on to over the years with huge operating costs is more or less a dinosaur. You’re seeing the systems build smaller-focused deliveries out in the suburbs.”

Condo-mania, redux

David Strachan, vice chairman and president of the western region of Palm Beach Gardens-based Rendina Cos., attended the meeting on behalf of advisory board member Bruce Rendina, who died in December after a long battle with brain cancer.

Mr. Strachan, who works out the firm’s La Jolla, Calif.,office, said he was surprised by the recent resurgence of interest in medical office condos. Even though the board members guessed that condos compose fewer than 10 percent of medical office development deals, interest from physicians is once again surging.

“Physicians are interested in ownership of real estate, and in the case of condos they’re attracted by gaining 100 percent ownership in a medical property,” said Mr. Strachan.

“Back in 1991 or so, if you heard the words medical condos you went running because of all of the problems they’d had… We talk to the docs about the potential problems with the ultimate sale of the condo years from now, about the inflexibility of the space if they need to expand or decrease their needs, and they’re still interested. I’m surprised that the docs are asking for this.”

Board members said the condo market is hottest in places where land is more readily available, such as Las Vegas, Florida, Phoenix, and California – even though land in such areas tends to be expensive.

Mr. Strachan added that hospitals are even becoming interested in having medical office condos developed on their campuses. “Five years ago that would have been unheard of for a hospital to listen to such a proposal.”

“I can see where a hospital would love it because it keeps their docs on campus – they don’t run out after their lease expires,” said Glen T. Preston, vice president of acquisitions for Nashville, Tenn.-based Health Care Property Investors Inc. (NYSE: HCP).

Mr. Strachan added: “But I’ve seen the other side of it, when the doctors can’t sell their condos. And you know who they turn to in those instances? The hospital to buy them out.”

Physicians want in

Even though board members expressed their distaste for medical condos, they acknowledged that more and more physicians are looking for a piece of the action when it comes to owning healthcare real estate. As has been documented on the pages of this publication many times, more and more doctors are investing in the MOBs where they occupy space.

Mr. Moloney said physicians are increasingly interested in investing because real estate has out-performed other types of investments in recent years. Should real estate start to decline, perhaps there will be a drop in requests from physicians looking for investment opportunities, he said.

A growing number of physicians, in fact, are starting to become interested in investing in the operations side of an MOB, a surgery center, or an imaging center.

“Where they can legally do it, I think that’s actually more of a sustainable investment,” Mr. Moloney said.

“They want both, but at the end of the day they have a better understanding, more control, and more of a potential for a good return on the operations side,” said Mr. Moloney. “If they’ve got $100,000 to put into both the real estate and the operations side, it looks like they’re starting to put more into the operations side.”

Competition is steeper

When asked whether competition has increased in healthcare development, board members agreed that it has.

“We seem to find ourselves competing with the same people, but there are definitely others in the space that weren’t there before,” said Kevin O’Neil, president and senior managing director of Trammell Crow Healthcare Services (TCHS) in Dallas.

“We keep hearing there are so many more developers out there, even though we don’t see all that many of them. What we see are firms increasing their footprints by opening new offices in new markets.”

As far as Mr. Farrar of Windrose is concerned, more companies are responding to development requests for proposals (RFPs) these days.

“You’re seeing a lot more RFPs and a lot more people responding to RFPs,” Mr. Farrar said. “I mean it’s great for you guys (the folks on the financial side of development), but our firm generally doesn’t win the RFP race, especially as it relates to MOBs.

“That’s because you’re seeing developers take risks at very low cap rates because service providers convince them that development deals should be at cap rates that are close to sales cap rates. And when something has a long development cycle, developing a hospital, which takes 24 months to develop, locking in at a rate at the start of the development process doesn’t seem to work.”

The development market has certainly become more “transparent,” Mr. Moloney of Cain Brothers said. “Hospitals used to talk to two of the developers they knew and now they’re more likely to hire someone to manage a competitive development process. As a result, it goes from two potential developers to six or eight.”

Mr. Preston of HCP added that, “in fairness to the hospital, they do have a board to report to and can’t just give the deal to the developer on their board, which is how they used to do business.”

Years ago, developers knew their competitors, most of who were headquartered in the same region.

“Competition these days is coming from different parts of the country, where it used to be more regionalized,” said Mr. Strachan of Rendina Cos. “There was a group on the West Coast and we all knew each other. Now we see people we hadn’t seen before. And just the same, we’re getting invited to other parts of the country as well.”

As the discussion about competition continued, Mr. Lewis had a question for Mr. Moloney, who often works with health systems.

“Jim, what is the relationship is between price, experience, and expertise when a hospital is deciding who to go with? Does it vary from hospital to hospital?”

Mr. Moloney answered: “One thing to remember is the business philosophy or the resonance of the way the hospital system views the world. Sometimes when a hospital has developed five buildings with a developer, they find that they’re in lockstep with that developer. At other times, they might go through a competitive process and find someone else they’re in lockstep with, someone who is more consistent with their philosophy.”

Mr. Moloney added that hospitals typically don’t simply go with the low bidder.

“The margin usually isn’t very big between the lowest bid and the bid they choose,” he said. “It comes down more to structure and philosophy. Some systems want someone who will be there for them in 20 years. Some systems want a developer who is experienced with certain types of doctors, and are fluent with the issues the doctors are wrestling with. More and more, systems are looking for the right partner.”

In addition, many projects today are anchored by surgery centers, cancer centers, and other hospital-related services, according to Mr. Strachan said.

“Because of that, hospitals are looking for a partner that can show them five examples of surgery centers, cancer centers, that they’ve built for hospitals,” he said. “And on top of that, the medical office space has to be competitive, too.” q

Next month we will publish the third and final article with highlights from this roundtable discussion, focusing on healthcare real estate trends to watch out for in 2007.