Special Report: BOMA Capital Markets (August 2007)

Interesting times for investing



By John Mugford

The high-paced, high-priced medical office building (MOB) investment environment of recent years might be in for a bit of a lull – nothing drastic, just a period of adjustment as sellers and buyers find a common ground during a period of higher interest rates and stricter underwriting standards.

In addition to less favorable interest rates, the slight slowdown might be an offshoot result of difficulties in the sub-prime lending market, as well as some other factors.

Even so, healthcare real estate is still considered a solid, long-term investment because of the nation’s demographics – namely, the aging of the population – and constantly advancing medical technologies.

These were some of the messages conveyed during a panel discussion at the recent “2007 Medical Office Building and Healthcare Facilities Seminar” held July 18-20 in New York.

The three-day seminar was sponsored by BOMA International and presented prior to the organization’s main conference, which was held July 21-24. About 500 people were in attendance for the healthcare facilities conference – a drastic rise in participants from the 30 or so people who attended the first such conference about five years ago.

During the course of two days at this year’s conference, there were a total of 16 separate educational sessions and panel discussions. Topics included strategies for building off-campus healthcare facilities, putting together clinical joint ventures as tenants in medical facilities, analyzing demand for MOBs, monetization trends, and others.

Healthcare Real Estate Insightswas on hand at the BOMA conference and plans to provide coverage of many of the panel discussions in coming editions. For this issue, we’re starting our coverage with a session that concentrated on current trends for MOB investing.

The panel discussion was called: “Capital Markets: Opportunities and Challenges for Investors and Lenders.”

The moderator was Brent Tharp, a senior VP with GE Healthcare Financial Services (GEHFS). The panelists were:

■ Ray Lewis, executive VP and chief investment officer with Louisville, Ky.-based Ventas Inc. (NYSE: VTR);

■ Jim Kornick, senior director of Marcus & Millichap’s Healthcare Real Estate Group in Washington, D.C.;

■ Jeff Piehl, director of valuation services for the Denver office of Cushman & Wakefield; and

■ Ari Weinberger, VP of New York-based Shattuck Hammond Partners LLC.

As the discussion began, Mr. Tharp of GEHFS pointed out some of the impressive statistics concerning the future of healthcare and its anticipated growth. For example, Mr. Tharp noted that healthcare comprises 16 percent of the country’s gross domestic product (GDP), and that the growth of healthcare spending exceeds the growth of the consumer price index (CPI).

“All of this bodes well for healthcare and healthcare real estate in the future,” Mr. Tharp noted. “And the states with the highest population growth are the states with the most facilities and the most facilities in need of repair. Another important factor is the fact that the oldest-aged (people) in the country are expected to be the fastest growing segment of the population, and that will translate into more demand in the medical office building industry.”

Mr. Tharp noted that outpatient demand has grown strongly in the past decade or so, as there were a reported 2,400 ambulatory surgery centers (ASCs) in the country in 1996 compared with about 5,200 today.

MOBs remain strong

When Mr. Tharp asked the panelists whether investing in MOBs remains a solid option, Mr. Lewis of Ventas answered: “There are a couple of things going on. As far as yields are concerned, they remain attractive compared to core real estate, such as traditional office, retail, industrial and multi-family. And that’s keeping medical an attractive investment opportunity.

“As a result we are still seeing interest from new sources of capital. The question is, however, how long will that be sustained, especially with the rising interest rate environment? That will eventually have an impact on leveraged buyers and what they’re willing to pay for properties.”

Mr. Lewis said that in core real estate – retail, industrial, office, apartments – “You’re starting to see an impact of the bad debt markets … on real estate, particularly on the B and C properties, and those transactions are becoming choppy.”

He added that it doesn’t take much of a leap to see that trend transcend to medical real estate.

“To this point we haven’t seen it yet,” Mr. Lewis added. “But it’s not a question of whether we’ll some of this, but when.”

Mr. Piehl of Cushman & Wakefield, said: “We’re seeing equity buyers who were previously in the number one position being moved away from that because … sellers are not willing to take that risk given the current market and interest rates.”

Mr. Tharp then asked the panelists if they are seeing any indications “that we’re in for some kind of market correction or anything like that — that REITs (real estate investment trusts) will stop buying or that financing just won’t be available any more?”

“Whenever you have a situation where interest rates are rising it will take a little while for buyers and sellers expectations to adjust,” Mr. Lewis answered. “The cost of capital goes up, and therefore what buyers are willing to pay for a property goes down and sellers are still expecting a certain price … and for a time they are not willing to accept less than what their expectations are.

“I don’t think there will be a drying up of transactional buying,” he continued, “but we might find a period of time when (there aren’t as many) transactions … because of the expectations of buyers and sellers are not in synch – at least for a period of time.”

Even so, Mr. Lewis and the other panelists noted that because of the statistics shared with the crowd at the beginning of the session – those showing the strong future growth trends for healthcare in general – indicate that there will continue to be capital flowing into the MOB sector.

And that’s not just on the development side – where yields are higher – but also as hospitals look for ways to fund their growth and look at their existing MOBs as non-core assets that can be sold to pay for growth, the panelists noted

“So there might a temporary dislocation,” Mr. Lewis added, “but in the long run you’ll continue to see transactions.”

When to sell?

Mr. Kornick of Marcus & Millichap, who spends his days marketing MOBs and medical facilities, says it’s been difficult for sellers, including health systems, to know when to sell – or “pull the trigger,” as he put it.

“Owners have watched prices rise, rise, rise and cap rates drop, drop, drop,” he said. (Capitalization rates – or cap rates, for short – are the projected annual returns on a real estate acquisition.) “But in the last four to six weeks many of them have been contacting us and saying that now might be the right time for them to sell.

“And we still think it’s a good time, but when we meet with these folks we’re telling them that their properties might not sell at the same price they would have sold for just 90 days ago – we have to make sure that they are willing to accept that outcome. But prices are still very good compared to historical values, and in the long term medical is still considered a very steady investment.”

Mr. Tharp asked the panelists about the impact of stabilizing MOB cap rates, which had dropped significantly and steadily for several years to levels of less than 7 percent, even 6 percent.

Mr. Piehl said: “I think investors have stepped back and are figuring out the cost of capital. But if a deal still fits into their puzzle they’re still going to be very aggressive in going after the assets they want.”

Mr. Lewis said that cap rates were driven lower by “neo-buyers,” including large institutional investors, that entered the market in recent years. But those same buyers might be shying away when they learn more about the differences between medical real estate and core real estate.

“The neo-buyers came into the market thinking that this is a good deal for a low-risk product,” Mr. Lewis said, “and we can get a 6 cap, or a 6½ or 6¾ cap rate compared to high 4s and low 5s for a general office building. The difference is, and this is for those who have not been in the market for a while, it’s not like a downtown Manhattan office structure where rents can be raised significantly when the building is turned over. The tenants and the hospital systems are not going to allow that or they are certainly going to meet it with strong resistance.”

The panelists noted that investors are attracted to MOBs when they want to trade growth for stability. In MOBs, rent growth is limited fairly closely to inflationary growth, even on renewals, panelists said.

“You might have a relative higher going-in yield but you have a more consistent IRR (internal rate of return) over the life of the investment,” Mr. Lewis said. “And in consequence that creates … a fundamental difference between where cap rates should go – and that’s always a more limiting factor.”

Mr. Tharp said: “We talk qualitatively (about) cap rates, but what about quantitatively, where we’re looking at cap rates going in … and what about a discussion about how people are underwriting them?”

“One of the unique things about being a REIT is that we take a view, when we acquire things, that the residual doesn’t have a tremendous impact on IRRs – we look at a 10-year hold scenario as one potential way to measure our return,” Mr. Lewis said. “But for us it’s really a matter of getting a spread over our cost of capital. And if there’s value creation and some upside, then we can defend it in some way. But it is not the primary investment driver for us.”

The panelists also noted the following during the discussion:

■ As people become more interested in medical properties, they’ll be able to understand that cap rates will find a bottom.

■ The investment market is currently in a bit of a balancing act, balancing high demand with the current state of debt markets – rising interest rates, stricter underwriting techniques being used by lenders and problems with the sub-prime markets, among others.

■ MOB rents have remained stable at market rates.

■ Buyers who do their homework are still aggressively pursuing MOBs – and they’re making correct assumptions.

What to do?

As the panelists talked about the troubles in the sub-prime market, Mr. Tharp asked if any of the panelists foresee any concerns for the MOB investment market as a result.

“What’s happening in the sub-prime market is something that I think people saw coming,” Mr. Weinberger of Shattuck Hammond responded. “And it was a mudslide that they chose to ignore. It’s interesting that in the economy today a ripple in the sub-prime can affect everything and anything. But I think a lot of that is just people get picky and are waiting for the shoe to drop … I think that over the next six months – as we see what’s going on in our own market – that whatever noise is taking place in the sub-prime market will probably go away.”

One panelist noted that over the next six months, as medical products continue to perform well and don’t show signs that the problems with the sub-prime problems market are causing any ill effects, things will ease up.

Mr. Tharp asked the panelists, “Perhaps if the market is stepping back a little bit, what would you recommend that owners should do today? What would you recommend they do if they’d been thinking about selling a portfolio? Should they refinance it with long-term debt or sell out?”

“There are a lot of variables that go into that decision,” Mr. Lewis responded. “And there are a lot of strategic decisions as well: What are the objectives of the seller? Do they want to have a continuing interest in the operations of the facility? If they do, I would recommend getting a joint venture partner as the better approach. At least at this moment in time perhaps a refinance strategy is not the way to go, given where interest rates are – they’re still at relatively attractive levels versus historical levels – and where underwriting standards are, which have tightened significantly.”

The time to do a refinance was probably six months to 12 months ago, Mr. Lewis noted.

“But I still think there’s a lot of capital looking to get into this space so it’s probably a good time to be doing a joint venture deal. But one of the variables to consider is tax considerations.”

Mr. Tharp said he’s seeing tenant-in-common (TIC) investors still coming into the MOB market place, “especially on off-campus deals, not necessarily portfolios. Are any of the panelists seeing that? And are they being successful?”

“We’re not seeing that as much,” Mr. Weinberger said. “But then again, we deal more in portfolios and TIC investors are not necessarily in that market. But we’re curious to see where individual investors coming off of 1031 exchanges put their money back into the market.”

Mr. Kornick added: “We’ve got two different TIC deals and they’re both under water right now. They thought they were buying bonds …”

Development is strong

The panelists noted that many MOB transactions today include agreements for the buyers to do future developments for the seller, typically a health system.

“Obviously there’s a higher yield on development – it depends on what type of risk you’re taking on a development,” Mr. Lewis said. “It’s certainly one of the interesting trends right now – to combine the disposition of an asset with an agreement for future development. And it’s then up to folks like Ari … to determine the value of a future development pipeline.”

Mr. Weinberger noted that he and others “see the delivery of healthcare changing – outpatient care is continually increasing and changing. When people go to see their doctor they don’t expect to sit in an old waiting room in an old building anymore. For that reason health systems have started to see value in new developments as a competitive advantage over other systems in their market. The other point is that health systems are moving into new markets and they see new buildings as a good way to conquer those new markets. We’re always talking to our clients about development as a carrot to drive pricing.”

Mr. Lewis noted that development investors are often considered short-term investors who want to maximize their returns over a three- to five-year window, which is in contrast to today’s pricing and cap rates, which call for longer term investments. He said it will be interesting to see how the current trend plays out.

The challenges?

When Mr. Tharp asked the panelists what they see as the biggest challenges facing investors, Mr. Lewis responded: “From the investment side, the biggest challenge is finding the appropriate risk-reduction returns on the investment. And also, getting a consistent flow of transactions is a challenge right now, too. From an operating side, the challenges are fairly consistent over time: keep a relatively petulant group of tenants happy. The money comes right out of their incomes. The level of a doctor’s rent depends on whether they join a country club or buy a new car – keeping them happy and in return keeping the health system happy is always important.”

Mr. Weinberger said that one of the problems that his firm sees is physician owners who want to be real estate moguls like Donald Trump.

“But we are seeing more and hospitals looking to a physician ownership model to keep their docs happy,” he added. “It’s something they want to see offered to them and so buyers and developers are obliging.”

Mr. Piehl said one of the biggest challenges he sees is a decreasing number of serious bidders for MOB offerings.

“Two years ago we probably had 10 to 12 serious bidders on a property, but today we need to manage the expectations of the sellers so they don’t think that will happen again,” he said. “You’re probably still going to have 10 to 12 bidders on a property but only one or two will really (be serious) in the sellers pipeline and make a realistic bid.”

Mr. Tharp said that in today’s environment, hospitals are shying away from buyers that don’t already have a portfolio of MOBs.

“That’s true,” Mr. Weinberger said. “If you want to be buying a larger portfolio, the hospitals want you to have experience.”

Panelists noted that physician investment in MOBs has added complications for investors, especially when one party wants to get their liquidity out of the property and the other owners do not.

“It does create certain complications when an owner wants to get liquid and a physician does not,” Mr. Lewis said. “In many circumstances there will be liquidity agreements put into the agreement from the beginning. But (physician investment) does create some inherent conflicts, especially if the physician doesn’t want to get liquid when the owner does.”

Mr. Piehl noted: “From an evaluation standpoint, we’re not seeing anything different in a physician-owned buildings than other buildings … We’re not seeing any difference in underwriting in those situations.”

Mr. Lewis noted that “if you want to be in the business (of owning MOBs) you have to deal with physician ownership – you have to be willing to work with physicians because there are increasing opportunities for some level of physician participation.”

Tharp noted that lenders look favorably on buildings where tenants who are making an investment in their building in the form of tenant improvements (TIs).

“In today’s market place, tenants are likely to get a TI allowance of $40 or $50 a foot – but no one can make TIs for that price,” he added. “In some cases doctors are putting much more than that into their TIs – $40 or $50 per foot of their own money. Some docs in California are putting in $100 a foot. From a lending perspective, that’s great.”

A member of the audience asked the panelists: “What are the key metrics you look at when going into a new market?”

“As Brent pointed out early in the presentation it’s important to look at the correlation between population growth and healthcare advances,” Mr. Lewis said. “When we look at the dynamics of a healthcare market we ask whether there are strong health systems and payors, and what are the dynamics between the systems and the payors? Who’s growing in that market?”

“And obviously you want to look within a micro market – what’s the availability of additional sites and the development availabilities around that campus? And what are your rents compared to the other MOBs in that market? That’s more of a traditional real estate underwriting.” q

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