Cover Story: Crafting its place in the HRE market

MedCraft Investment Partners has been laying low during a difficult year in the MOB space, but after bolstering the firm it is ready to invest up to $800 million during the next three years

By John B. Mugford

Although MedCraft and its predecessor company have been active in the healthcare real estate (HRE) market for decades, the firm is, in a way, starting anew in 2023.

Now known as MedCraft Investment Partners (MIP), the Minneapolis-based firm is a 50-50 joint venture of longtime HRE developer MedCraft Healthcare Real Estate, which is now the development arm of MIP, and Cadence Healthcare, a subsidiary of Chicago-based Cadence Capital Partners. Since it was formed in late 2020 and began investing in 2021, MIP has gotten off to a good start, reaching the $300 million investment milestone by mid-2022.

But the HRE and medical office building (MOB) investment market has gone through a roller coaster ride since MIP’s launch, with a rather big slowdown taking place in the latter half of 2022 and heading into 2023.

Those ups and downs began with the COVID-19 pandemic in 2020, as market activity in most business sectors, including HRE, basically came to a halt for a period of time.

In the next year, 2021, the MOB sales market came roaring back, but it was marked by some of the highest pricing in the history of the sector. Yields, or capitalization (cap) rates, fell to record lows as many large, institutional capital sources entered the market and drove pricing up and, as noted, cap rates down, making it difficult for traditional HRE firms to compete for offerings.

By the time 2022 rolled around, a changing economic environment hit the real estate market, including HRE, as inflation took off and, in reaction to that, the U.S. Federal Reserve Bank executed a series of increases to its Fed Funds target rate to raise interest rates and cool the economy. This, of course, led to an increase in borrowing rates and caused a widening gap between sellers’ asking prices and what buyers were willing to pay. Debt financing became difficult to get as many lenders took a wait-and-see attitude concerning the economy.

These factors made it difficult for most investors to make as many acquisitions as they would have liked.

MIP was no exception.

At the time of its launch, the firm, which was basically starting its investment platform from scratch, had a goal of building a $500 million portfolio within two years. By the end of 2022, the firm was not far from that goal, as the value of its portfolio was more than $350 million and, with some acquisitions pending, approaching $400 million.

“It really didn’t come as any surprise that 2022 was a bit of a letdown from an acquisition activity perspective for us,” says Michael Bennett, who along with Jay Soave are the chief investment officers of MIP. “When interest rates rise so quickly as they did, it tends to cause issues for everyone in a sector like this, and we were in the same boat as a lot of our competitors, with all of us trying to find our footing.”

He notes that MIP has been “very prudent and careful” in making acquisition decisions, adding that “when there is uncertainty and issues with the capital markets and there’s a pricing disconnect between sellers and buyers, we tend to be very careful.”

Jon Lewin is chief financial officer (CFO) of MIP and one of three principals of MedCraft Healthcare, the development arm of MIP, as well as the overall firm – along with Eric Carmichael and Keith Beneke.

“We still want people in the sector to know that we want to put money out, we’re ready to invest,” Mr. Lewin says, “and, by the way, we have no problem with cap rates going up, interest rates going up, as long as we can meet realistic targeted returns and yields, which is where I think sellers and the buyers have gone their separate ways over recent months but do, recently, seem to be coming closer together again.”

And yet, MIP, whose major investment partner is Chicago-based Harrison Street Real Estate Capital, reiterates that its strategy has always been, and still is, to remain pragmatic and thoughtful when making acquisitions instead of just putting money out to reach certain investment goals.

As a result of all the economic and market factors that have taken place since its founding as an investment platform, MIP has indeed been prudent during its short history. Although MIP’s leaders are not complaining and realize that overcoming various market disruptions is part of the business, they do acknowledge that doing so during its rather short history has proven to be challenging because of economic and market conditions.

Revista, a firm that compiles and distributes a variety of HRE data for its subscribers, indicates that the MOB volume in the second half of 2022 – a time when interest rates rose dramatically and valuations of properties were difficult to nail down – fell by about 59 percent from a year earlier, when the MOB transaction volume for the second of 2021 totaled $13.14 billion. The second half of 2022 saw MOB sales of just $5.4 billion – a figure that excludes the $10 billion or so of MOB sales that took place as part of the July merger of Nashville, Tenn.-based Healthcare Realty Trust Inc. (NYSE: HR) and Scottsdale, Ariz.-based Healthcare Trust of America.

As the market enters 2023, Mr. Lewin says, “It does seem like buyers and sellers are starting to come back together, for the most part.” Also, as he noted above, cap rates have been rising and there does seem to be more clarity on where pricing should be for HRE facility offerings.

Revista data confirms Mr. Lewin’s observation about cap rates, as it shows that the average cap rate for MOB deals in the fourth quarter (Q4) of 2022 was 6.3 percent, and rising, heading into 2023. That was up significantly from much of 2022, when the average cap rate hit a historic low of 5.9 percent.

It was during 2022, according to Messrs. Lewin and Bennett, that MIP “looked at” about $2 billion worth of potential deals, “but we only ended up investing about $100 million during the year on acquisitions,” Mr. Lewin says. “We did a lot of underwriting, there was a lot of machinations, there was a lot of consternation around pricing and we did what we could.

“I would say that while we acquired a lot less than we thought we would, we were successful in the fact that we did not buy some deals that we looked at, did our due diligence on, and passed on,” he adds, “because we probably would’ve regretted many of those had we made them. We’re not the type of investor that just has to go out and make investments that are potentially in what can be considered a gray area of whether or not it will work out financially.”

Coming out of 2022 and setting new goals

As a result of seeing what looks to be a market that is stabilizing – as far as Messrs. Lewin and Bennett and many others in the sector are concerned – MIP has set new acquisition goals.

“Our portfolio is currently approaching about $400 million worth of investments,” Mr. Bennett notes. “We were on a pace to get to that $400 million mark during 2022 before the market shut down. But we’re going to get there soon.”

The firm’s new goal is to make “$200 million worth of acquisitions in 2023, which is definitely a tapered-back goal from our original goals for the year,” Mr. Lewin says. “We realize that’s not as big of a number as our goal would be in a more normal year, but given where the market is now and just was, we think it’s appropriate and something we can and will accomplish.”

According to Messrs. Lewin and Bennett, MIP has a number of transactions in the pipeline that will set it well on its way toward that $200 million investment goal in 2023, perhaps even allowing it to hit the $300 million mark.

From there – after 2023 – the firm’s sights are set even higher.

“We want to grow that number pretty significantly over the next three years, and our goal is to have $1.4 billion under management three years from now” (by the end of 2025), Mr. Lewin says. “That’s a pretty big number, about $400 million per year (in 2024 and 2025).”

How MIP finds deals

As it moves forward and has plans to increase its investment activity, the officers of MIP say they plan to accumulate the firm’s portfolio the old-fashioned way, with plenty of hard work and buying assets one at a time, or in smaller portfolios.

“About 70 percent of our pipeline is off-market, or lightly marketed deals by the non-primary medical office brokers,” says Mr. Bennett. “Myself, with my background as a medical office broker, as well as Mike Janus (VP of investments with MIP) and Jay Soave (Mr. Bennett’s co-chief investment officer), are out pounding the pavement. We spend a lot of time on the phone building our business and letting people know we are active MOB investors.”

He noted that during the slowdown in acquisition activity in 2022, the firm spent a lot of its time “not only building up our operations but executing our business plan, which is really to build a team that can find and acquire off-market transactions. We build on the relationships that we already have in the health system network, and we’re also doing the hard work of smiling and dialing to find the right opportunities.

“And we’re continuing to build a portfolio that we believe is ‘best in class’ and includes assets that we truly believe in for the long term, not assets that we want to flip in three or four years.”

Among the deals that MIP closed in 2022 that demonstrates how it goes about finding and buying assets was an August purchase of a 61,515 square foot, multi-tenant MOB in Grand Island, Neb., about 150 miles west of Omaha, for $25.6 million.

According to MIP, the Prairie Commons Medical Office Building at 3563 Prairieview St. was completed earlier in 2022 and is on the campus of the newly opened $71 million, 64-bed Grand Island Regional Medical Center. The multi-tenant MOB is anchored by two collaborative health systems, Hastings, Neb.-based Mary Lanning Memorial Hospital and Lincoln, Neb.-based Bryan Health.

MIP found the deal by, as Mr. Bennett likes to note, being out “in the marketplace digging and looking for opportunities and putting our tentacles out there.”

He first learned of the opportunity in a newspaper article chronicling the development of a new hospital and MOB campus in Grand Island. He then spent about a week trying to track down the owner of the MOB on the campus, which turned out to be Omaha, Neb.-based Frankfort Square Partners, a private real estate investment firm.

“After we finally got a hold of them, we had several in-person meetings,” Mr. Bennett notes. “And in the end the owners decided to go with MedCraft to sell to because of our relationship with our capital group, Harrison Street, the certainty of our being able to close, as this was a forward take-out commitment, and the feeling that they were doing business with an organization that stood by what we say we’re going to do and knowing that we would not look to re-trade or arbitrarily change the deal. We beat out at least one other bidder for the property.”

Another example of an acquisition that fit in with the firm’s strategy and its ability to find off-market deals took place in February 2022 in Guilford, Conn., where MIP acquired the three-building Patriot Medical Park complex for $28 million.

MIP was made aware of the opportunity through what Mr. Bennett calls a “good brokerage relationship that brought us the deal as an off-market” opportunity.

“One of the larger tenants, an area hospital, was an existing hospital relationship that MedCraft had developed,” he notes. “So we approached them about their commitment to the building and how it fit in with their strategy, and, as a result, we not only got a great report on their performance in the building but we also received early news that the system was going to purchase another large tenant in the building.

“As a result, the percentage of the hospital’s leased space would be increasing by 30 percent. I think it’s a good example of the type of buildings we look for, those anchored by hospitals, but it also showcases the fact the relationships we build and the type of information and insight we look for and receive is a reflection of the company’s decades of experience and performance.”

Still careful, pragmatic

Even though MIP has rather lofty goals, that does not mean the firm will forego its strategy of looking for deals that fit with its overall strategy and priorities.

The officers say the firm is ready to grow the portfolio significantly over the next three years in part because it had time to focus on strengthening its portfolio and improving the company’s capabilities to find more deals to its liking during a time when acquisition activity slowed in 2022.

“We battened down the hatches and improved our operating company last year,” Mr. Bennett says, “as we hired some people and started to prepare for what we thought we would see in 2023, and that is that we think there will be a growing number of opportunities in the year ahead.”

As it looks to become more active once again, MIP says it will continue to look for off-market deals, or deals that are not widely marketed. It will also make sure its deals make financial sense.

“We’re not paid to put money out,” Mr. Bennett says. “We’re paid to manage investments and to make good choices and to lock in returns for our investors.”

MIP does have a major investment partner, as noted earlier. That partner, Harrison Street, which invests in what it calls alternative real estate properties, including HRE facilities, has about $55 billion of assets under management (AUM).

Interestingly, in 2020, Mr. Bennett, along with Mr. Soave of Cadence Healthcare Group, helped arrange the investment partnership between Harrison Street and MedCraft.

MedCraft, at the time, was not heavily involved in acquiring properties, but it was looking to do so on a larger scale in order to become more of a “full-service” HRE firm with the ability to make acquisitions while still developing projects and growing its asset management portfolio, all of which can help it better serve its client base, which is focused heavily on health systems and large physician groups.

In the process of working together, the officers with MedCraft and Cadence Healthcare say they realized they had similar values and goals, and decided to form the new MOB investment platform as a result.

Mr. Lewin adds that the firm’s philosophy involves owning the assets it acquires “for a long period of time, as we plan to share in the success of the assets. We’ve built our organization and our infrastructure around the types of assets that we have determined will be successful over the long haul, and our part in that is to develop and maintain great tenant relationships and client relationships, with a goal of doing a really great job on that side of it.

“Our goal in our partnership with Harrison Street has always been to aggregate a portfolio, so us being an acquirer of large, marketed portfolios probably is not the route we will take because we would then be the capital or the take out for those aggregators, which is not our plan.”

He notes that in acquiring facilities one “property at a time, or developing properties for clients, those deals tend to lead to other transactions, so there could be multiple transactions.”

An example of this is evident in the work that MedCraft Healthcare and MIP have done in Tucson, Ariz.

There, MedCraft was engaged by Tucson Medical Center (TCM Health) to develop projects on the system’s Rincon campus, in the southeastern part of the city.

The relationship started with MIP’s acquisition of a two-story, 44,000 square foot MOB on the campus, which is about 13 miles from the system’s flagship, 641-bed Tucson Medical Center. MedCraft established “an attractive co-investment real estate opportunity to recruit full-time physician tenants” to the campus, helping grow TMC’s primary and specialty care practices to serve more patients while providing ongoing economic returns for clinicians.

In October 2022, MedCraft finished its first new development project on the campus with the completion of a 17,000 square foot ambulatory surgery center (ASC). The campus will also include a 60-bed hospital set to open in 2023.

Richard Prevallet, VP of facilities & construction with TMC, said in a news release that MedCraft, “as a collaborative and fully aligned partner … provided unique solutions that align with TMC’s goals. From creative financing options, providing TMC and physicians with real estate investment opportunities in both facilities, and highly skilled facility planning expertise, they have helped us position the Rincon campus for long-term growth.”

Firm’s roots were as a developer

As noted, MIP was formed to enable MedCraft Healthcare to better serve its clients by adding to its offerings, and also to grow its AUM.

Shortly after the formation of MIP, Mr. Lewin told HREI™: “We’re just so excited about what this means for us and our longtime clients, as we really look at this as the second phase of our evolution as a full-service healthcare real estate firm. Our goal has always been to play a role, perhaps a small but still important one, in the success that our clients have in delivering services to their patients. And we really feel that with our added capabilities we can do so even better.”

MedCraft Healthcare’s roots date back to the 1980s, when it was known as Frauenshuh Healthcare, part of Minneapolis-based Frauenshuh Commercial Real Estate.

At one point in the 2000s, as the healthcare arm of Frauenshuh went about developing HRE projects, it landed a large project in Nebraska. The company could have funded the project internally, but doing so would have depleted it of much of its capital at the time.

While serving on a panel session in late 2021 at the BOMA International Medical Office Building + Healthcare Real Estate Conference in Dallas, Mr. Lewin explained to the audience that, at that time, Frauenshuh did not prefer to partner “with equity, but it was the right time for us to do just that, and when we went to seek a capital partner and sent out a little RFP (request for proposals), we had the folks from Healthcare REIT, now Welltower Inc. (NYSE: WELL), in our office within two days.

In 2010, Welltower acquired Frauenshuh’s development, property and asset management company and entered a joint venture (JV) partnership “on our existing portfolio to help seed that relationship – and over the next several years (Welltower) partnered with us on over 30 different assets.”

When there was a leadership change at the top of Welltower in 2015, with longtime CEO George Chapman retiring, the leadership at the REIT offered Frauenshuh Healthcare the opportunity to “take back our platform and go private with it.

“We jumped at the chance because one of the things we’ve always prided ourselves on is making sure that we are focused on our facilities,” Mr. Lewin said during the BOMA panel session. “We really thought this would give us the opportunity to help hospital systems and providers, including physicians, really be able to deliver healthcare effectively and efficiently within their particular market.”

Although the firm, which rebranded itself as MedCraft in 2016, believed its strong suit was as a developer, being focused solely on that aspect of the business “did not really provide us with any stabilized income other than the ups and downs and riding the rollercoaster of development,” Mr. Lewin explained to the BOMA audience.

“One of the things that we were at a disadvantage of when we came out of the REIT was the fact that we didn’t have an existing portfolio,” he continued. “We didn’t have anything to offer the brokers, and brokers were now running processes on development as well. So, one of the big reasons why we (formed MIP) and decided to get involved in the acquisition game and raising capital was that we wanted to stabilize our platform, and to have an active role with the brokers so we can continue to do what we’re really, really good at, which is developing and delivering new healthcare facilities.”

It was then that the firm met with Mr. Bennett of Cadence Capital Partners, whom Mr. Lewin called a “good friend of mine and a talented individual on the capital-raising side.”

After working with one equity partner, MedCraft then entered a programmatic investment partnership with Harrison Street.

“We feel very fortunate that our partner on the equity side is Harrison Street,” Mr. Lewin noted, adding, “They are truly a wonderful partner. They brought us in on some transactions and understood our expertise in certain markets, and they have always been really good people to work with and good friends.”

Although MIP is looking to increase its acquisitions over the next couple of years, MedCraft Healthcare’s development pipeline remains strong, according to Mr. Lewin.

After what could be considered a lull in its project pipeline in the aftermath of the pandemic, Mr. Lewin says the firm’s development activity, including projects in its pipeline, has been picking up steadily over the last year or so.

As of late 2022, Mr. Lewin said the firm had “five development projects in the pre-development phases, and we have another two projects that are currently under construction, one of which is about ready to open.”

MedCraft Healthcare performs both fee-for-service projects that will be owned by its clients as well as projects that it will own. It co-develops the owned projects with Harrison Street and adds them to the MIP portfolio.

Looking to the future

The executives with MIP remain quite bullish on the HRE and MOB sectors, as well as their place in it.

At a time when health systems are facing financial pressures like never before as a result of rising costs and sinking reimbursements, they say firms like MIP can provide capital solutions – even helping them expand their networks, if need be.

“I’ve been in the healthcare facility development and acquisitions sectors now for 19 years,” Mr. Lewin says, “and the busiest time we’ve ever had in our firm’s history was during the Great Recession, because economic difficulties put pressure on hospitals and health systems and physician groups, and it makes them think alternatively about how to best utilize their capital. Often, they turn to firms like ours that can do developments and acquisitions for them.”

On the acquisitions side, Mr. Lewin says, “Too much capital came into our industry the last three years, especially when it became known that these assets were pandemic and recession resistant. But it has been difficult for a lot of those capital groups to place their investments without a good strong operator as a partner, like we are for Harrison Street.”

Mr. Bennett notes that “rising interest rates have been tough on the acquisitions side, because of what it’s done to cap rates and potential sellers. But I also know that sellers are still able to take profit on deals that they’ve held for a significant amount of time, and there does need to be some recapitalizations of certain assets.

“I think the liquidity of the market will continue to ramp up from its downturn of last summer, and I remain bullish on the industry, I really am. And we’re in this for the long term. We didn’t come into this to see what we can accumulate in a two- to three-year period and sell it all and cash in our chits.”

To that, Mr. Lewin adds: “We think our platform and the way that we operate is going to provide capital to the best long-term investments in this sector. And while there might still be some credit hits to health systems and providers along the way, this sector is filled with good tenants who can pay their rents.”

He concluded by saying: “We’re looking to build a company that outlasts both Michael and I, and we’re looking to do it the right way and in a way where we have control of every aspect of our business, including the capital, which allows us to better serve our clients as well.” 