Special Report : HREI Editorial Board Roundtable, Part 4 (March 2007)

Developers could be sellers this year

MONETIZATIONS, RISING PRICES, CONSOLIDATIONS LIKELY TO CONTINUE IN 2007

By John Mugford

In three previous editions of Healthcare Real Estate Insights™, we have published highlights of a roundtable discussion that took place at our recent Editorial Advisory Board meeting in Chicago, providing a look back at 2006 development and investment trends, as well as a the board’s predictions regarding 2007 development trends.

The response from readers to the series has been great. Several subscribers called to say they’ve read every word and have utilized some of the information in their business strategy.

So here’s the fourth and final installment: a look at what editorial board members believe will be emerging trends in the areas of monetizations and medical office building (MOB) sales, pricing, mergers and consolidations, financial models, and government regulations – with a few other topics thrown in for good measure, and good reading.

Strong sales volume?

For starters, we asked board members whether they believe recent record levels of MOB sales volume can continue; board members responded with a strong “yes.” And while the biggest sellers will likely continue to be hospitals, developers are selling more and more facilities.

As they noted several times during the discussion, institutional investors have had a big impact on the medical real estate market for several reasons. Board members see the scenario continuing, at least until those investors turn sour on the product type or move on to something else.

“A lot of the volume in the (transaction) market in the last couple of years has been developer-brought transactions,” said James M. Moloney, a senior vice president with the San Francisco office of investment bank Cain Brothers & Co. “The difference is they used to sell buildings that were up and running for two, three, four, five years. But all of the capital in the market has given developers access to capital that they didn’t have before. And because it’s still relatively difficult to find investments in this asset class, that’s moved the whole sales process up stream – so now we’re seeing pre-sales or commitments to invest much earlier in the development cycle, frequently when the building’s just going under construction or is just into construction. And the pricing for those buildings is almost on top of what it is for stabilized product.”

“And the developers will continue to monetize as they look to grow, to move from being a three market firm to a 10 market firm,” said Kevin O’Neil, president and senior managing director of Trammell Crow Healthcare Services (TCHS) in Dallas. “They’ll follow clients around, or meet with people who they get invited in to see because they’ve done a good job for someone else.”

Pension fund buyers are just now starting to consider MOBs as mainstream investments, which should mean continued future growth for the industry, said Jonathan L. Winer, a partner with the Real Estate Advisory Services unit of New York-based Ernst & Young.

“The pension funds seem much more willing to allocate funds to medical real estate than in the past,” Mr. Winer said. “And that’s important because I think even with the influx of capital over the last few years, I wouldn’t say all of it represented true institutional pension fund money – because a lot of it came through alternative fund investments. Now, we’re really seeing where mainstream, long-term pension fund money is going into medical office. That is a positive for the industry.”

Mr. O’Neil of Trammell Crow agreed, saying: “The institutional investors seem to have taken their time to figure out exactly what medical real estate is and get comfortable with it. I think the MOB was kind of this big box voodoo that they didn’t know what to do with for a long time, mainly because there wasn’t a lot of data about the product type. And that made them uncomfortable, meaning there was a number of things they didn’t grasp.”

But those investors finally came around to medical properties when, as Raymond J. Lewis, senior vice president and chief investment officer of Ventas Inc. (NYSE: VTR), said, “They were looking at an office building at a four or a five cap or a medical office at a six-and-a- half or a seven. At some point they’re willing to take a risk. Even though some of the people who have been in the business a long time look at the cap rates of medical office and throw our hands up and say, ‘What are we doing?’ To the institutional investors, that’s not a very big deal.”

Board members noted that most of the value in the healthcare development business is created before a project breaks ground. For that reason, pre-sales or pre-construction commitments to acquire MOBs are likely to continue.

“It takes a long time to get all of the pieces set, to get pre-leasing going and the entitlement and all of that,” Mr. Moloney added. “But once you’re ready to put a shovel in the ground, it’s not like doing spec suburban office, where you’ve got one tenant. With an MOB, you usually have a good sense of what a medical building’s going to look like from a tenancy perspective and a cash flow perspective. And developers are able to capture a big chunk of that value very early in the process, much earlier than two or three years ago.”

Hospitals as sellers

When board members were asked whether hospitals would ever run out of product to sell in the not-to-distant future, they said health systems and hospitals will most likely be the main sellers in the transaction market for quite a long time.

“That won’t happen for a long time,” Mr. Lewis of Ventas said. “There’s still untapped potential. It’s the single largest real estate class in healthcare. So little of it is actually in untapped hands right now.

What about an infusion of capital?

“Hospitals will still want to sell because for them it’s also a matter of management and not having to deal with the real estate,” said David Strachan, vice chairman and president of the West region of Palm Beach Gardens, Fla.-based Rendina Cos.

What about in 10 years – will hospitals still be selling?

“There will always be hospitals that sell because they have to and hospitals that sell because they evaluate it as part of their overall structure and they think it’s a smart financial move,” said Mr. Winer of Ernst & Young. “Then there’s the idea that it’s kind of a trickle effect. Every year there are hospitals that do that because they look at it each year and they think this is the right time for this. And when things are tighter for hospital systems, for example whenever the government clamps down on reimbursement, then more hospitals feel pain and need an infusion of capital.”

“At the same,” Mr. Lewis said, “you’re seeing bad debt at historic levels and some other clouds on the horizon.

Financial models

As Murray W. Wolf, publisher of HREI™ continued the discussion, he asked board members if they could foresee any new financial models on the horizon.

“Are any of the various financial models growing in prominence?” Mr. Wolf asked. “We talked about condos, physician investment, etc.?… It sounds like you think physician investment will continue to be a big part of development deals. Do you see any other financial trends for 2007 and beyond?”

Mr. Moloney said he believes joint venture structures will continue to gain in prominence.

“You’ll see a lot of joint venture structures between operators, asset managers and capital providers,” he said. “And firms such as (Health Care Property Investors) have done some of that on a big scale. We know a lot of developer groups that are doing it on the program or building level, and I think you’re going to see a broad range of ways in which operators, developers and managers of these assets will connect and interface capital. I think those models will continue to evolve, but you should see a lot of those joint venture structures in many different shades.”

Mr. Wolf then asked whether physician investment in medical facilities could eventually fade. In an earlier discussion concerning emerging development trends in 2006, board members had noted that physicians became much more interested in investing in MOBs as reimbursements were reduced and the stock market became more volatile.

“If the Dow improves, will doctors go back to investing in stock instead of MOBs and real estate?” Mr. Wolf asked.

“The bigger risk is physician reimbursement,” Mr. Moloney said. “I think it’s reasonable to expect some reimbursement uncertainty in the future, and how much it affects and impacts doctors is a more immediate concern.”

M&A time

Consolidations and mergers of firms involved in healthcare real estate are likely to continue, board members noted. Those consolidations often take place, board members said, as a way for certain companies to acquire product types they desire. For example, a firm that has long concentrated on senior living facilities might acquire an MOB developer and owner with a portfolio of buildings as a way to enter the medical office sector. Other board members joked that because transactions have become so complex these days, it’s just as easy to acquire a whole company with a vast portfolio as buying a few buildings.

Such consolidations and mergers will continue to fuel the transaction market, board members said.

“With consolidation there’s automatic transaction volume because you put two portfolios together and suddenly there’s a subset of buildings that doesn’t fit too well that will soon be a on the sale block,” said Mr. Moloney.

“I think you will see more of it because when you talk about the benefits of scale in terms of transactions,” said Mr. Lewis, whose firm, Ventas Inc., recently entered a definitive agreement to acquire Canada-based Sunrise Senior Living REIT and its 74 assisted living facilities for an estimated $1.8 billion. “It’s just as hard, in some cases, to do a small deal as it a big deal, and consolidations maybe take it to another level, but the benefits that get out of it seem to be worth it. I think you will continue to see more consolidations.”

“There aren’t as many more pure plays out there in this sector,” added Mr. Winer. “I think the environment favors that – it’s hard to find that pure play out there.”

But if there is to be a “pure play” transaction, Mr. O’Neil said he believes it will be a big deal, a “monster,” because it would be between firms “you conceive of not needing to combine.”

Mr. Winer said he see two firms finding each other out of a need to grow.

“There could be two smart firms out there that say we need to be larger because – I haven’t looked at your multiples lately – but if you get rewarded because of size, it would be a no-brainer to get together.”

Mr. O’Neil said it’s hard to predict the future because unforeseen events take place every year.

“We’re focused on our space, which we really are there to serve the bigger industry,” Mr. O’Neil said. “But certainly what happens with HCA – is the biggest leveraged buyout ever? I think so – and some of these Catholic systems as they’ve come together… with some of those things, there’s so much of an asset base, like the $10 billion revenue company HCA, that you start to look at megatrends like that and you don’t know what will come from it, but you assume something relative will come from it. It could be in either category – maybe they’re selling a lot of hospitals, or maybe some MOBs with that. Perhaps that’s a case where we didn’t see a lot of deal flow coming but all of a sudden there it is.”

Prices continue to rise

As everyone looks forward to the future, the big question that seems to be on the minds of many in the industry is whether the price of medical facilities will continue on their astronomic ascent, or whether they will level off at some point. Also, board members were asked whether average cap rates for healthcare facilities could possibly fall below current levels, which seem to be around 7 percent, even lower.

When asked whether pricing will drift back to some sort of normalcy in the near future, board members noted that the cost of buying medical properties is likely to continue rising as long as construction costs continue to increase and institutional investors remain interested in the sector. As a result, rents should continue to increase as well.

Mr. Moloney said when looking at pricing, one has to look beyond cap rates.

“It’s not all about cap rates, in fact, I think it’s about IRRs (internal rates of return),” Mr. Moloney said. “And when you compare commercial office cap rates and you hear people talk about them being in the fours, they’re also projecting them into IRRs and then they’re maybe in the mid-nines or 10s in a lot of those markets. And that’s because they have really rapid rental increases.”

But Mr. Moloney added that the folks who underwrite MOBs are “loathe to look at anything but a CPI-based increase to market rents. It’s very hard to pass through rents. So it’s really the IRR pricing that I think should be the relative metric – it’s very difficult to compare apples to apples on IRRs. But it’s hard to do it on cap rates, too.”

Mr. Lewis of Ventas noted that cap rates, as they normally do, should move in synch with interest rates.

“For that reason, I think you’re better off to look at the spread differential between your return and the underlying risk-free rate, which has compressed a fair amount,” Mr. Lewis said, “but it’s still relatively wide compared to other real estate investments. That is a big question and I would argue that it’s found sort of an equilibrium.”

Glen T. Preston, vice president of acquisitions for Nashville, Tenn.-based Health Property Investors Inc. (NYSE: HCP), recalled a transaction he was involved with in 2003 at a cap rate of about 9 percent.

“We thought that was the greatest thing we’d ever heard,” he said. “But two years later, we were in the eights, and then the sevens.”

In looking into his crystal ball, Mr. Winer said he doesn’t see much change in pricing in 2007.

“I’m sorry to say this because it’s not very exciting, but when it comes down to it I think we’ll see a lot more in 2007 of what we saw in 2006,” Mr. Winer said. “I don’t see returns moving a whole lot during the year. I continue to see capital coming into the business, I don’t see … much change.”

But Mr. Lewis offered a caveat by saying, “But I do think if the spreads go away, I think the capital goes away, too … so if that spread gets bid too far away, I think all the capital that has actually caused the spread to compress starts to move away, too.”

Mr. Moloney noted that he does not necessarily agree with Mr. Lewis on that point.

“I think we can see the premium for medical relative to CBD office, core-core office, narrow considerably on an IRR basis, not necessarily on a cap rate basis,” Mr. Moloney said. “I think there’s so much pent up capital trying to get into this asset class that it’s very frustrated because it’s very difficult to get into this market. I think that that will take a number of periods to equilibrate.”

As far as Mr. Winer is concerned, even though medical real estate is considered a hot investment and a relatively newfound investment for institutions, the market cannot totally separate itself from the greater real estate market.

“I think as the real estate market goes, so goes our industry,” Mr. Winer said. “So if cap rates or interest rates are heading up, I think medical will go that way, too. We can’t totally stand apart from the general trends, unless something unusual happens, some kind of external factor that we can’t predict right now.”

Worries, concerns?

When asked about any concerns they might have about the healthcare real estate sector, such as potential new federal regulations or reimbursement changes, board members said they do, indeed, have some concerns.

“I think a possible threat – and I don’t know if it’s immediate in 2007 or farther out, is the fact that some of the money coming into the sector is not as experienced or doesn’t have the knowledge of the marketplace,” said Mr. Lewis, reiterating an earlier point. “What happens if that money gets burned? What would the impact of that be on the capital flows to the industry?”

While such a scenario could provide opportunities for some in the business, including some board members, it could be bad for the industry overall, Mr. Lewis noted.

“If investors were to come into the sector and have a bad experience it could be a long time before there’s the same access to capital that we’ve seen lately,” Mr. Lewis said.

Mr. Moloney agreed.

“It is a big issue – investors who really don’t understand healthcare all that well,” Mr. Moloney said. “If there is some fundamental shift in reimbursement, for example, out of Washington, I think you could see an immediate step back from people not as experienced with this sector. It doesn’t change Ray’s appetite or Glen’s appetite, but the pension fund that thinks they want to diversify into medical and then they see a big reimbursement shift might say ‘Wow, I don’t get this? I need to think about this better before I start investing.’ That’s the big capital risk.”

Others noted that they, too, are concerned about potential changes coming from the federal government.

“With the change in power in Washington now, I think they’ve got to come back with some reimbursement changes – clearly there have got to be some changes on the horizon,” Mr. Winer said.

“2007 is the 10-year anniversary of the last cataclysmic reimbursement changes by Congress,” said Mr. Moloney. “It’s been a while since we’ve had it and I think we’re due.”

Mr. Lewis concluded with this thought: “The folks in the hot seat with the federal government right now are the pharma companies. That’s where the feds will start with regulation changes. But we should assume that our industry is not too far behind.” q