Transactions: Rising demand for one-off MOB deals?

TWO CALIFORNIA DEALS INDICATE THAT PRIVATE BUYERS ARE LOOKING TO MEDICAL

By John Mugford

Out in California, two recent medical office building (MOB) transactions probably won’t make headlines in many business or real estate publications, be they local or national.

Even so, the deals are garnering coverage here in Healthcare Real Estate Insights^™ because they seem to be representative of a growing trend in healthcare real estate, where private investors are becoming more and more interested in acquiring smaller MOBs. One place where this is happening is in California, which is considered a high barrier-to-entry market.

In this “under-the-radar” segment of the MOB market, the transactions are often “one-off” deals originating from private sellers.

In one of the recent California deals, a private buyer from the San Jose area acquired a 25,708 square foot MOB in Sacramento that is across the street from – but not technically on the campus of – Methodist Medical Center, which is part of San Francisco-based Catholic Healthcare West (CHW).

The capitalization (cap) rate for the property, known as the Hospital Drive Medical Building, was in the mid-7 percent range, according to the seller’s broker, Evan Kovak of the San Diego office of Marcus & Millichap Real Estate Investment Services.

The buyer is the Quetnick Family Partnership LP, while the seller was Alamo, Calif.-based Mendell Properties LLC.

In the other transaction, Arcadia, Calif.-based Positive Investments, which owns a variety of commercial real estate property types, acquired the off-campus Center Medical Building in Huntington Beach for $7.88 million. The 55,693 square foot, multi-tenant MOB was about 74 percent occupied at the time of the closing, which provides the buyer with a significant “value-add” opportunity, according to the broker, John Smelter, senior director of the healthcare real estate group at Marcus & Millichap.

“We’re seeing a lot more activity between private sellers and private buyers, and a lot of the buildings have anywhere from 20,000 square feet to 50,000 square feet,” Mr. Smelter says. “It’s basically the type of transaction that the industry was built on before the large institutional investors took notice and sales volumes and cap rates went a bit crazy, especially from about 2006 to 2008.”

Sacramento deal

While the Sacramento MOB, which is located at 7501 Hospital Dr., sold for just $5.3 million – at a price per square foot (PSF) of about $206 – it received plenty of attention from potential investors, most of them private and most of them, but not all, based in California.

Mr. Kovak says that as the country’s real estate investment trusts (REITs) and other big investors look for larger MOBs and multi-building portfolios to hit the market, things are stirring among private owners and investors in marketplace where MOBs are priced below $15 million.

“There was a lot of interest in this building,” says Mr. Kovak. “And that’s because there are plenty of private investors out there who would like to get into the medical space, or would like to continue to increase their holdings in medical. But it’s just not possible for many of them to compete with the REITs or the other large, institutional investors for those larger properties or portfolios. They can’t pay what the larger investors can, they don’t have that kind of capital, and in many cases they don’t have the background or expertise in medical like the healthcare REITs do to make those types of acquisitions.”

Interestingly, a couple of REITs took a look at the Hospital Drive Medical Building, with one publicly traded REIT showing interest – mainly because it owns other MOBs on or adjacent to the Methodist Medical Center campus and was interested in rounding out its portfolio there, according to Mr. Kovak.

The eventual buyer, the Quetnick Family Partnership, owns quite a few multi-family residential properties and is interested in building a medical portfolio, he says.

The building was completed in 1976 and has 10 smallish tenants, including primary care practices and other specialists, with no one group occupying more than 15 percent of the facility. The CHW hospital does not have a direct presence in the building, even though many of the tenants are affiliated with the hospital. As noted, even though the MOB is across the street from the hospital, it is not on a ground lease.

Occupancy is at about 98 percent, where it has been since about the year 2000, Mr. Kovak says.

The buyer, according to Mr. Kovak, funded the acquisition with about 55 percent to 60 percent equity and the rest with debt.

Huntington Beach deal

As was the case with the MOB in Sacramento, the Center Medical Building in Huntington Beach commanded quite a bit of interest from investors, according to Mr. Smelter.

“It was like most of my listings in that there are typically a half dozen or so offers,” says Mr. Smelter, who represented both the buyer and the seller, a dissolving partnership.

Built in 1985 – which Mr. Smelter says is relatively new for an MOB in its market – the Center Medical Building was billed as a “Class A” property with immediate access to and visibility from U.S. Interstate 405. With 55,693 square feet of space and a closing price of $7.875 million, the PSF came out to about $141.

The PSF was low, perhaps, because the occupancy rate stood at about 74 percent at the time of the sale. According to Mr. Smelter, a hospital tenant had previously vacated some administrative offices in the building. In addition, occupancy is low because a number of tenants with month-to-month leases left their spaces.

Because Mr. Smelter does not consider the tenancy “stabilized,” he declined to divulge a cap rate for the transaction, saying doing so would not be comparing “apples to apples.”

However, he notes that the building, because of its location and quality, has a lot of “value-add” potential.

“The buyer is planning to make a series of upgrades to attract tenants, and the building is located in a prime shopping area, right across from the Bella Terra Mall, which is the premier shopping destination in Huntington Beach,” he says. “Plus, a new Costco is being built right there as well. If you’re not going to be on campus, it’s good for a medical building to be in a retail location that’s convenient for patients.

“So with the improvements the buyer is planning to make, and if they have good and aggressive leasing agents who can find potential tenants currently located in older, sub-par buildings, which most of them are in that area, I think this new owner can realize an occupancy rate of up to 90 percent within 18 months, perhaps even 12 months. That could lead to a very nice return for them on their investment.”

Private market

As far as Messrs. Smelter and Kovak are concerned, the two sales detailed above provide a good representation of what’s taking place in the MOB sales market today, especially in places like California. During the past couple of years, the two Marcus & Millichap brokers, working independent of each other, have closed a majority of the “brokered” MOB transactions in the Golden State.

“While I would call most of these deals ‘under the radar’ type of transactions, in a number of them, the major medical office investment players have shown some interest in the properties,” Mr. Kovak says. “But in most cases, the private, ‘under the radar’ buyers are often willing and able to outbid them for these types of assets.”

That’s because quite a number of private buyers, according to Mr. Kovak, are more willing to move forward on properties that the larger buyers would consider risky. Most institutional buyers, he notes, are looking for new, on-campus, trophy assets with significant hospital sponsorship.

However, entrepreneurial private buyers are willing to execute deals for both on- and off- campus, multi-tenanted buildings that do not necessarily have hospital credit.

“These private buyers are savvy and they’re looking for the same securities that the institutional buyers are seeking, however, they don’t look at just the cookie cutter deals that the larger buyers want,” he notes. “By being willing to acquire multi-tenant properties that might be slightly older, they can usually find properties that are not being chased by institutional capital. And these buyers know that in California most of the existing medical office product is considered old by the standards of the REITs and institutional buyers. So if they can find a building completed in mid-1980s to early ‘90s, well, they consider that to be relatively new compared to most of the available product.

“And in dense markets such as Los Angeles, Orange County, San Diego and the Bay Area, there is very little land for future development. West Coast, private buyers know the market and understand this.”

Because medical tenants do not necessarily have many options for leaving their current spaces, Mr. Kovak notes that many of the private buyers he meets are willing to acquire, and sometimes prefer buying, multi-tenanted buildings with shorter remaining lease terms as opposed to buildings with just a couple of larger tenants, including a hospital.

“We do coach these private investors to allocate a reserve budget in case their spaces become obsolete over time,” he adds.

On a good pace

According to statistics recently compiled by Marcus & Millichap for Mr. Smelter’s upcoming “National Medical Office” fall newsletter, there were 94 MOB transactions nationwide in 2011 through August.

The average deal size up to that point: $7.82 million, which is right in line with the price that Positive Investments paid for the Huntington Beach MOB. Last year, according to Mr. Smelter, the average MOB deal nationwide sold at an average price of $15.52 million.

“That average was skewed by some of the larger deals that took place,” he notes.

“We’re on a good transaction pace this year, as there were just 97 transactions in all of 2010,” Mr. Smelter says, noting that Marcus & Millichap researches each deal to make sure that it constitutes what he calls a “true” MOB transaction.

“I think we’ll see anywhere from 150 to 170 deals for all of 2011. And with the average price in that $7 million to $8 million range, we’re looking at a total sales volume of somewhere in the $1.3 billion to $1.6 billion range.”

Both the sales velocity (number of deals) and volume (total price paid) projected for 2011 are a return to what he calls “normalcy” in the MOB transaction market.

The number of deals projected for 2011 is significantly higher than the 66 transactions that Marcus & Millichap tracked in 2009 but is also significantly lower than the 292 deals it tracked in 2007.

What he also considers “normal” today is the number of transactions taking place between private sellers and private buyers.

“We’re looking at about half of the deals today being in that $5 million or under price range,” Mr. Smelter says. “The existing inventory today has a lot of buildings in that 20,000 to 50,000 square foot range.”

However, Mr. Smelter also notes that most of the MOBs being developed today are larger, as many have 80,000 square feet of space or more.

“I do think that in years to come the average transaction size will get pricier as buildings sizes increase and the rents move higher,” Mr. Smelter says. “I can see transaction sizes averaging about $10 million in a few years, even under what I consider normal market conditions.”

With the average cap rate for MOBs hovering at about 8.1 percent – according to Marcus & Millichap’s statistics – Mr. Smelter notes, as he’s done before, that now is a good time to be both a seller and buyer of medical buildings.

“Right now, we’re looking at a spread of about 500 basis points or more when it comes to the spread between the average cap rate and the interest rate on 10-year Treasuries,” he says. “And that is in keeping with what the band width was prior to the boom years of MOB transactions. Our research shows that the spread was also about 560 basis points back in 2003, and it was about the same back in the 1990s as well.”

When institutional investors accelerated demand and drove down cap in the mid-2000s, that spread was squeezed. In 2006-07, Mr. Smelter says, the spread between Treasuries and the MOB cap rate dropped to a low of about 240 basis points.

“Buyers are loving the environment right now as they can lock in at good interest rates and get double-digit returns on certain deals on a levered basis,” he says. “And sellers are finding it a good time to sell because they can still get a good cap rate compared to the historical cap. Our research shows that the average cap rate since the early 1990s has been about 9.2 percent, and we’re at 8.1 percent right now. That’s not too bad.”