Transactions: 2006 and Q4 MOB Report (Febuary 2007)

MOB investment might change in 2007 

REAL CAPITAL ANALYTICS FORESEES REGIONAL VARIATIONS, MORE DEVELOPMENT

 

By Murray W. Wolf

 

At first glance, 2006 appeared to be the same old story for medical office building (MOB) investors: rising prices per square foot and falling capitalization rates. In fact, that has been the consistent theme since at least the first quarter (Q1) of 2003 – and 2007 is likely to bring more of the same.

But a closer examination of the 2006 MOB transaction data reveals some interesting nuances, according to Dan Fasulo, a managing director with Real Capital Analytics Inc. Real Capital is a national research and consulting firm with offices in New York City and San Jose, Calif. The firm bases its data on independent reports of transactions involving properties and portfolios of $5 million and greater.

While prices and cap rates continued their familiar trends, Mr. Fasulo says the drivers of those trends have changed. From 2002 to 2005, he says, declining interest rates and rising rents for medical office space in many markets created a situation where overall MOB prices logically increased. A rising tide lifted all boats. But a significant change took hold in 2006, he says.

“Now, what we’re seeing is a market more driven on fundamentals than just the overall tide rising, and we’re seeing premiums develop in certain markets where the supply-demand equation is significantly out of whack,” he says.

Regional variations

There was a considerable gap between prices and cap rates on the East and West coasts compared to the rest of the United States in 2006.

Real Capital found that the weighted average price for MOBs last year was $379 per square foot in the Northeast and $248 per square foot in the West. That was well above the national average of $238 per square foot, and far above the averages in the Mid-Atlantic, Southeast, Southwest and Midwest.

It should be noted that Real Capital included in the 2006 data the November sale of the Center for Life Science in Boston (CLSB) – a research tower that some industry observers would not categorize as an MOB. That 702,940 square foot property sold in November for $473 million – a whopping $673 per square foot – a deal that clearly skewed the overall numbers. But even if you exclude the CLSB, the average price for MOBs last year in the Northeast was $267 per square foot – still well above the national average.

(For more information regarding the sale of the CLSB, please see “Lyme squeezes cash out of assets” in the December edition of our affiliated publication, Bioscience Real Estate Insights^™.)

Likewise, the weighted average cap rate was the least in the West, at 6.6 percent. That was less than the national average of 7.1 percent, and well below the cap rates in the rest of the nation.

“Instead of the whole tide rising nationwide, it’s more of a market-by-market scenario,” Mr. Fasulo says. “I think that’s going to be the story this year.”

Mr. Fasulo says we might be seeing a bifurcation going on based on the supply-demand equation for each market.

“It mainly seems to be focused on your markets on the coasts where the supply is very constrained and it’s very difficult to find suitable sites to build these types of properties. Basically, the markets are so dense that there’s a rush to purchase any of the existing properties that come on the market.”

He continues: “The problem is not that developers don’t want to build this type of space. It’s usually they’re outbid by other types of development, whether it be residential or commercial office.”

With limited land available for new development in many major East and West coast cities, MOB development opportunities are limited. That constrains supply, increases demand and sparks aggressive bidding when existing MOBs come on the market.

“However there are other markets where pricing has not increased at the same rate and a few markets that certainly have more room to add supply, like your Texas market, per se, or even certain markets in Florida, where they have the land to build these types of properties,” Mr. Fasulo says.

MOBs situated on hospital campuses usually offer obvious advantages. Their proximity to acute-care hospitals provides convenience for physician-tenants, staff and patients, and assures greater stability for developers and investors. But land constraints are another reason why developers tend to focus on on-campus MOBs; there’s often no other land available at a feasible price.

More development

Although the development of new MOBs might be limited in densely developed areas, Mr. Fasulo says we are likely to see more development in the market as a whole. In part, that’s because the supply of investment-grade MOBs might be starting to dwindle.

A lot of significant MOB properties have traded during the past few years, Mr. Fasulo notes, and there is only a finite amount of these properties in the country. He likens the situation to the retail real estate sector

“Our clients keep asking why mall volume – sales volume – is down so much in this country. I go, ‘Because all the malls have already traded. Everything has changed hands,’” he says.

Unlike retail properties, however, Mr. Fasulo said Real Capital hasn’t developed an estimate of how many MOBs there are in the United States. In part, that’s difficult because there is no universal definition of what constitutes an MOB. The CLSB deal mentioned above provides just one example of how the classification of a property can be rather subjective.

So, Mr. Fasulo says he’s not sure how close the MOB market might be to the point at which all the desirable properties have been traded. But it could be only a matter of time.

“Eventually I think we’re going to hit that situation in medical office where many of the prime properties have already changed hands and they’ll have to wait until a new market cycle before they trade again,” he says.

“Many of the large players who have focused on this group had originally only focused on buying existing assets,” he continues. “But now we’re seeing actually more and more money funneled into new development. Rents have come up in many markets and rents are finally at the point where maybe it justifies new construction in several markets and that wasn’t the case several years ago. So we are seeing more money is going into new development.”

In a typical deal, a local operator who knows the market gets the approvals, Mr. Fasulo explains. “Then they bring in the money partner who takes 80 percent of the deal,” he says. The investors are usually major REITs or institutional investors. “That’s the most likely scenario that we’ve being seeing as of late.”

Volume still rising

Although the supply of desirable assets might be dwindling, the MOB investment market still has legs if last year was any indication. Volumes continued to rise throughout the year.

Total MOB sales volume was $3.747 billion last year, an increase of 26 percent compared with 2005, Real Capital found. The number of properties sold was 258, an increase of 7 percent.

“There’s been more and more investor interest in this niche over the last several years and it makes sense when you look at the amount of capital that’s chasing real estate right now,” Mr. Fasulo says.

“And then you just have the general real estate market, which is certainly pushing up activity,” he adds. “But on top of that is this tremendous demographic wave that everyone is staring at. There is going to be a tremendous amount more demand for this type of space in the near future.”

Other key metrics for the 2006 MOB market included an overall weighted average cap rate of 7.0 percent, an average mortgage rate of 5.92 percent for 5- to 10-year fixed-rate conduit mortgages and a 94 percent average asking price achieved.

As MOBs become a more-accepted asset class, it is becoming easier to obtain market data, Real Capital’s Mr. Fasulo notes.

One reason is that more publicly traded real estate investment trusts (REITs) are investing in MOBs and they are required by the U.S. Securities and Exchange Commission (SEC) to disclose the financial details of their transactions, he says. Another reason is that more investors are buying MOBs using the Commercial Mortgage-Backed Securities (CMBS) market to finance the deals, which also require a significant amount of public reporting. (CMBS are debt securities backed by loans secured with commercial real estate.)

“We’re still not all the way there yet, but we’re getting better,” Mr. Fasulo says. q

Data provided by Real Capital Analytics. Based on independent reports of properties and portfolios $5 million and greater. For more current deals, cap rates and property details, please visit www.rcanalytics.com.