What will 2007 bring?

HREI EDITORIAL BOARD LOOKS AHEAD FOR TRENDS

 

By John Mugford

Look into your crystal ball and predict what’s going to happen in the healthcare real estate industry for the remainder of 2007 and beyond – development, financing, monetizations, consolidations, you name it.

It’s not all that easy. After all, who can really predict the future?

Here at Healthcare Real Estate Insights^™ we think we know of a group of people with a better-than-average chance of playing Nostradamus and prognosticating some upcoming trends. They are the members of our HREI^™ Editorial Advisory Board, a group that certainly must be considered among the leaders, and among the most-knowledgeable, in the industry.

The editorial board members recently gathered for a meeting in Chicago to discuss a variety of topics, including development and acquisition trends they saw emerging in 2006, as well as coming trends for 2007 and beyond.

To date, we’ve written articles about the board’s discussion concerning recent acquisition trends (Please see “2006 legacy: High prices” on page 1 of the December 2006 edition), and about development trends last year (Please see “LTACs, high-acuity MOBs on the radar” on page 23 of the January 2007 edition).

In this article, we’re highlighting the board’s discussion concerning coming trends in 2007 and beyond – the importance of lining up payer contracts, development trends, emerging product types, the evolving MOB, and others. Next month, we’ll look at their predictions concerning monetizations, financial models, pricing, consolidations and federal regulations.

Line up those payers

The recent HREI^™ Editorial Advisory Board included a discussion concerning the current and looming importance of garnering contracts with healthcare insurance providers, or payers, before embarking on certain types of medical developments. Those developments include physician-owned acute-care hospitals, as well as medical office buildings (MOBs), which now offer a much wider array of services than in the past, such as surgery, imaging, acute care and others.

James Moloney, a senior vice president with the San Francisco office of investment bank Cain Brothers & Co., said: “I think an important trend that we’re looking at is that a lot of capital has flowed into the healthcare sector, which has allowed doctors to kind of sever that traditional relationship they’ve had with hospitals as their capital partners. The linkage that I think will really drive the success of these ventures on a go-forward basis is whether they can get access to payer contracts.”

On the flip side, the health insurance firms are, in some markets, being cautious about developing relationships with newcomers, especially in cities they consider to be well-served, according to board members.

“I would imagine the payers, who are certainly very savvy about their business, are looking at markets and making judgments,” said Jonathan L. Winer, a partner with the Real Estate Advisory Services unit of New York-based Ernst & Young. “And I would imagine when they see a new hospital they might say, ‘Why do we need this facility?’ This market is well-served and another facility is certain to drive up costs, ultimately because of the way it will pull certain services out of the hospital.”

Mr. Moloney noted that Baylor Health Care System in Dallas is a good example of a provider that utilizes its relationships with payers to build its outpatient network.

“Baylor has a very deliberate outpatient strategy that involves partnering with a surgery center company and physicians,” Mr. Moloney said. “But the way Baylor makes sure that it stays in that loop – and the glue that really holds it all together – is not Baylor’s capital, because they’re not putting all that much capital into it. The key is their access to payer contracts.”

A bit of a chill?

As the board members discussed the importance of payer contracts, they discussed the recent announcement that a new doctor-owned acute-care hospital in Houston had recently defaulted on its note.

The facility was Houston Town & Country Hospital, a $50 million project that opened in early 2006 with 100 beds. In recent weeks, property owner Medical Properties Trust, a real estate investment trust (REIT) based in Birmingham, Ala., announced that it was selling the hospital as well as an adjacent MOB and the 26-acre parcel to Houston-based Memorial Hermann Healthcare System. Memorial Hermann plans to use the facility as a long-term acute-care hospital (LTAC).

Fred Farrar, president of the Windrose Medical Properties division of Toledo, Ohio-based Health Care REIT NYSE: HCN), said Town & Country’s inability to gain payer contracts is what doomed the new physician-run hospital.

“The Houston example is very interesting because you would think that that’s a very diversified, non-concentrated payer market, right?” said Will Roberson, formerly of GE Healthcare Financial Services and now the director of real estate for CIT Healthcare.

“There seem to be a lot of different payers and a lot of different systems. If one person goes and puts a stamp on this hospital and says we’re not going to let you get paid – that’s a very interesting dynamic. I would think that a market as diverse as Houston would not have a problem like that, but obviously it happened there.”

Mr. Moloney noted: “It’s true; the three-hospital markets are the ones where the hospitals have more sway with the payers and can be more effective at chilling the access.”

In recent years, Mr. Farrar said, he’s noticed about three or four general acute-care hospitals being built by physicians and their capital and development partners.

“We’ll see the defaulting of the Houston hospital puts any kind of chill on that type of development,” said Kevin O’Neil, president and senior managing director of Trammell Crow Healthcare Services (TCHS) in Dallas. “That’s pretty quick for a hospital like that to fail.”

Mr. Farrar added: “Before you build something like that you really have to take a look at the history of the market and what are the political ramifications of getting the payer contracts.”

Physicians and developers looking to build hospitals without an affiliation with an existing system need to be aware of the difficulties they face. Not only can lining up payer relationships be difficult, but so can meeting regulatory issues.

“We’ve seen physician groups or someone who wants to sponsor a new acute-care hospital that has $3 million or $4 million and not really understanding the ramifications of what they’re trying to do,” Mr. Farrar said. “Opening a hospital, equipping a hospital, funding the losses, and sitting down and looking at that and saying what does that really do to my cash flow?

“And so some of these people who are financing hospitals on a non-recourse basis, just like Town & Country in Houston, which was financed on a non-recourse basis. Well, if it gets too difficult for the docs they can easily walk away from a $100,000 to a $200,000 investment – that probably won’t change their lives too much. That’s much easier than having to write another check to get through the startup losses. That’s really the challenge.”

Mr. Farrar added: “They also have to remember that certifying a new hospital takes at least four to seven months to get Medicare certification, and then you can’t even go get payer certification until you’ve got Medicare certification.”

Development trends

As the board members looked ahead to development trends in 2007 and beyond, most were in agreement that new MOBs, and the physicians who occupy them, will continue to add more ancillary services, such as surgery, imaging and more.

As physicians continue to add such services to their practices, “that creates a new need for real estate,” Mr. Roberson said.

“That is definitely something we’re seeing,” he continued. “And the docs are certainly prepared to lease it for a long time, or own it.”

Mr. Moloney of Cain Brothers added: “I don’t know if it’s product type or tenant type. But the small, onesy, twosy ORs and surgery centers that had the added network model are – in many markets – going to have a rough go of it. That profile of tenant is looking to be a riskier tenant model than it was five years ago.”

As Mr. Moloney continued, he noted: “And that gets back to the whole payer thing. I think for the next five years, paying attention to the payer relationship in markets and how that impacts the tenants is going to be important.

“I don’t know if that will be in the next two years or the next five years, but I think right now we’re on a trend toward a little tighter control of networks that’s also concurrent with this trend toward this consumer directed healthcare, which is not necessarily consistent. They could diverge or they could come together. It’s not clear which direction they’ll go and it’s not clear to me that the consumer spending model’s going to take or not. But in the short term, I think networks will be important.”

Even though board members noted that in some instances physicians, because of the new influx of capital, have the ability to break away from hospitals, there are still many projects and services where hospitals and physicians are likely to team up. Now that the federal moratorium on specialty hospitals has expired, board members said they foresee quite a bit of partnering between hospitals and doctors in the development and operation of such facilities.

“If you go back to the early days of ASCs (ambulatory surgery centers), physicians operating the ASCs were not successful models,” Mr. Farrar said. “As a result, you had for-profit operators come in and do the ASC operations for the physicians and the hospitals. And now, the recent moratorium on specialty hospitals allowed the hospitals exactly what they wanted – it gave them a chance to catch up in the game and partner with the physician groups and build the stand-alone facilities to match their needs. And it helps them keep their relationship strong with their physicians.”

Emerging product types

As the discussion about development trends continued, board members talked about future product types. And in doing so, they couldn’t help but touch on the topic that dominates many conversations these days: rising costs.

“I think we’re going to see a continued focus on construction methodology and cost…,” said Mr. Winer. “There are techniques being used that can potentially shave $25 a foot off of construction costs. In the lower rent markets, that seems to be the only way to get a building done these days. Using those cost-saving methods will continue to be a differentiator for a developer who can compete and has examples of delivering a good product at a lower price.”

There will also be a more intense focus on “green buildings” and medical facilities with Leadership in Energy and Environmental Design (LEED) certification, according to board members.

“There will be a lot of discussion and action concerning these design features that help make buildings more efficient from an operating expense, especially from an energy-usage standpoint,” Mr. Moloney said. “The whole LEED concept and green buildings, you’re going to see that talked about more and more. Partly, for marketing reasons, it plays well in the not-for-profit hospital world. But it also makes sense for pure economics. As energy costs grow, that becomes more important piece of the total life cycle cost of a building.”

Perhaps an obstacle to alternative construction methods and architectural designs lies with the institutional investors.

“A lot of them are very skittish about alternative methods, and for that matter, materials,” Mr. Winer of Ernst & Young said. “If it’s not brick, they get worried. But there are markets out there that need solutions, and some of the most sought-out solutions come in the form of lower costs.”

Mr. O’Neil of Trammell Crow added: “One of the tricks on the construction-cost issue depends on what you do and how you save that money. With the influx of the institutional money, the question remains what they’ll let you do. Those things don’t necessarily mesh.”

The evolving MOB

As noted in earlier articles, board members believe MOBs will continue to add more acute-care services in the future.

“I don’t know if it will be in 2007, but I think you’re going to see more short-stay hospital beds in MOBs,” said Mr. Moloney.

“This comes down to the cost of construction. Adding new space to acute-care facilities is getting so expensive that MOBs are being turned into ERs. There’s still OB done in hospitals, and then very high-end surgery and high-end medical, but they’re trying to move everything else into outpatient.

“So, if you can move the low-end to medium- acuity surgery stuff – if you can move that to a medical office and if it needs 24-hour to 48-hour stays, you’re going to see more and more of that. But that’s typically going to be more affiliated with hospital campuses.”

However, states with strict regulations could put a damper on such innovations, said David Strachan, vice chairman and president of the West region of Palm Beach Gardens, Fla.-based Rendina Cos.

“In many states you’ll have to bring the entire medical office up to the state standards for acute-care facilities,” Mr. Strachan said. “I know this is the case in California. And when that happens, it drives up the rents, which of course drives the doctors crazy. So you might see ancillary buildings and medical office buildings – perhaps not the same structures.”

Mr. Roberson said that 2007 could see some new experiments in product types, or at least combinations of product types.

“We might see some experiments – I wouldn’t necessarily call them trends,” he said. “But there could be a combination of inpatient rehab and drug/psych facilities. Some companies are emerging around that.

“And, what with the reimbursement changes in LTACs you might see some experiments of combinations of LTACs and step-down SNF (skilled nursing facility) beds. It’s a way to take advantage of not getting reimbursed in an LTAC by capturing the reimbursement in an SNF. All of it revolves around reimbursements.”

On campus or off?

As board members talked about MOBs, a light-hearted debate ensued about whether on-campus facilities will continue to have superior value over off-campus MOBs.

The discussion began after Mr. Winer of Ernst & Young said: “It an interesting concept that medical office buildings used to sell at a discount to … their equivalent suburban office counterpart. That’s not really true anymore.

“You could argue that on-campus buildings are still such a superior position – even with restrictions – that it’s much more stable investment as opposed to suburban office. When you go off-campus, though, they run the gamut from being just as good as on-campus to being a very risky investment where you really have to know what you’re doing.”

Mr. Moloney added: “The touchstone question for medical offices always is: Is there a reason for this building to be here? For on-campus, the answer is yes because there’s a hospital here. For off-campus, you really have to have a compelling reason for it, especially in five and 10 and 15 years from now.

“If you have a model that makes sense for the tenant mix in that building, I think you’re going to see those buildings perform well in the market place. The argument gets more challenged when you put up a 40,000 square foot MOB in a suburban market just because you’ve got the doctors to fill it.”

But Mr. O’Neil of Trammell Crow said the future might find that on-campus MOBs will not always be superior to off-campus.

“I question whether you’ll see the on-campus occupancy in the future that you see today,” Mr. O’Neil said. “And that could be because of all of the restrictions placed on the ground leases. I’m not saying it’s going to happen for sure, but there are some things happening in the market that might change the fundamental premise that if you’re on the campus your building will always be full. That might not be quite as reliable of a future predictor as it’s been in the past.”

David Strachan of Rendina Cos. disagreed.

“But a doctor only sells time,” he said. “Time is all they have, and if they can be more efficient and be on campus and make their rounds and see 10 more patients a day, that’s what matters to them most of all.”

Mr. O’Neil quickly responded. “We love on-campus – don’t get me wrong on that. But these are just some thoughts that we’re having from time to time as we look forward.” q

Next month we will publish our final article highlighting the roundtable discussion during the recent Editorial Advisory Board meeting in Chicago. In that article, editorial board members will discuss what they see as coming trends in 2007 concerning monetizations, financial models, emerging development products, pricing, and consolidations. They will also express some concerns they have about potential federal regulations.