MOB sales keep pace in 2006

CAP RATES DROPPED TO AVERAGE OF 6.8% IN FOURTH QUARTER

 

By Jessica Griffith

In the fourth quarter (Q4) of 2006, Cambra Realty purchased 120 South Spalding Drive in Beverly Hills, Calif., for $42 million at a rock-bottom capitalization rate of 4.9 percent. This 68,000 square foot medical office building (MOB) is fully leased and represents one extreme of the medical office market at the end of last year: hot properties in a hot California market selling for plenty of cold cash.

At the other end was a Detroit deal, Trinity Health Office Center in Novi, Mich., which sold for $9.1 million at a 9.1 percent cap rate. The cap rate is the expected return on investment after one year. The sale in Detroit was good news for that market.

“We saw a bunch of deals in Michigan and rumors of Michigan’s death are exaggerated,” says Yitzie Sommer, senior research manager for Marcus & Millichap in New York. The real estate brokerage firm compiles multiple data sources on MOB sales each quarter for a comprehensive view of the market.

According to Mr. Sommer, the Midwest recovers more slowly than the coasts after a recession. In 2006, the commercial office market in that region finally gained some momentum. That success filtered into medical office.

Sky-high demand

Nationwide, Q4 saw a total of 103 MOB sales totaling $731 million, according to Mr. Sommer. The previous quarter reported 90 deals with a total volume of $772 million. Cap rates fell to an average of 6.78 percent in Q4. In 2005, the average cap rate was 7.85 percent, and Mr. Sommer does not expect cap rates to fall much further than their current levels.

“If we haven’t hit the bottom, we are really close,” he says, adding that the real average probably is closer to 6.9 percent. Many brokers were unwilling to divulge cap rates and so he was unable to report that figure for every deal.

(It should be noted that Healthcare Real Estate Insights^™ also regularly publishes highlights from quarterly MOB sales data complied by the research firm Real Capital Analytics Inc. Those statistics somewhat differ from the numbers reported by Marcus & Millichap because the firms have different methodologies for gathering the data. The most recent Real Capital statistics were published in the February edition of HREI^™.)

Low interest rates in 2003-05 caused the initial depression in cap rates. When rates increased in 2006, rent growth was strong enough to allow cap rates to continue to fall. Rent growth is not expected to be as strong in 2007, but with only a marginal increase in interest rates expected, cap rates may experience a minimal increase but remain at historical lows, Mr. Sommer says.

Average price per square foot (PSF) for MOBs increased significantly from $188 in Q4 2005 to $215 in Q4 2006. But the increase from Q3 to Q4 in 2006 was only $1, according to Marcus & Millichap.

Rents are another indicator of the health of the MOB market. The general office sector likely will not perform as well in 2007 as it did in 2006, when office space experienced effective rent growth of about 8 percent, a “tremendously high” number. Mr. Sommer says.

This year, the effective rent growth likely will be 4 percent to 6 percent, still a strong number but an indicator the office market has hit its peak in terms of annual rent growth. When the office market is in recovery mode, medical office rent growth tends to mirror that of the general market, Mr. Sommer says. That is not true in a recession because the demand for medical office space is more consistent than demand for general office space.

Market by market

 

California remains the strongest MOB market with the largest supply of medical office properties. In addition, its average MOB cap rate, at 6.47 percent, is lower than the national average. California’s average MOB cap rate was 6.68 percent in 2005.

The most significant cap rate reduction occurred in the Northeast, where rates fell from 8.33 percent to 7.41 percent year over year, Mr. Sommer notes. The Southeast also had a large drop, from 8 percent to 7.26 percent.

The Midwest market was notable for its increased number of transactions, increasing from 92 sales in 2005 to 116 sales in 2006. In this report, the Midwest market includes Texas.

In recent years, market observers have noted time and again that the increasing demand for MOBs has been fueled, at least in part, by newfound interest from institutional investors. Such investors are typically focused on larger portfolios. A Q4 deal in Berwyn, Ill., a Chicago suburb, illustrates this trend. The MacNeal Hospital Buildings, a 101,000 square foot complex, sold for $22.7 million to Heitman Capital Management, an international asset manager.

“There still are a lot of private buyers in the market but once you get up in price, institutions and pension funds are purchasing properties,” Mr. Sommer says. Price, of course, is relative. He notes that a single office building in New York can sell for the total value of all MOBs sold in the country last year, which was $3.17 billion, up from $2.85 billion in 2005.

Mr. Sommer anticipates the MOB market will stay strong in 2007, with an increase in the number of transactions.

“Price per square foot might increase even if cap rates stay the same,” he says. He expects cap rates to stabilize in the first half of the year and then rise a little, but no more than 25 basis points.

One market to watch in 2007 is Phoenix, where Mr. Sommer says a significant number of new medical office projects are under construction. The Paradise Valley Medical Plaza in Phoenix sold in November to a private investor at a 5.91 percent cap rate, and two other Phoenix deals were reported in fourth quarter. He also expects to see more activity in Dallas and Houston, and continued interest in California markets.

“Not that many properties were put on the market (in California) and the ones that were on the market were commanding high prices because of strong investor interest,” Mr. Sommer says. q

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