In Good Health: A $750 Billion Sector -- And Growing -- Attracting Institutional Investors

[ By Peter Kloepfer ]

Avista 2 is a physician joint-ventured facility with an ambulatory surgery center featuring three operating rooms.

Five years ago, a medical office building (MOB) like St. Alexius Medical Center MOB III in Elk Grove Village, Ill., would have attracted scant attention from institutional investors. In those heady days before the Dot Bomb and 9/11, most institutions were able to achieve their investment goals by focusing on established real estate asset classes - office, industrial, retail and multifamily - as well as the soaring financial markets.

Now, half a decade later, Wall Street remains well below its record highs and commercial real estate has only just begun to show glimmers of a comeback. Meanwhile, so much investment capital is flooding the real estate market that capitalization rates have declined sharply for most traditional asset classes.

That combination of factors is prompting many institutional investors - pension funds, insurance companies, real estate investment trusts (REITs) and others - to take a closer look at medical real estate, a sector that had historically been dismissed as an alternative asset class.

Some might be surprised to learn that healthcare real estate is a $750 billion market - larger than industrial and almost as big as retail, according to statistics cited by Health Care Property Investors Inc. (NYSE: HCP), the nation's largest healthcare REIT. MOBs -- the most abundant and available option for medical real estate investors -- make up about 34 percent of that $750 billion.

The investment market for healthcare real estate is booming. The value of MOB sales nearly tripled from 2002 to 2005, growing from about $1 billion in 2002 to about $2.8 billion last year, according to research cited during a recent roundtable discussion presented at Columbia University in New York. During that same period, average MOB sale prices increased and capitalization rates decreased.

Alexian Brothers Medical Center opened in late 2005, satisfying the client's need for the kind of on-campus medical office space favored by patients and physicians.

As with all property types, MOB sale prices vary based on the asset, the market and other deal-specific factors. But nationwide, average sale prices are definitely on the rise. The average MOB now sells for about $200 per square foot, compared with slightly more than $100 per square foot in 2002, according to brokers and analysts who track the sector.

With so much capital flooding the overall commercial real estate market, cap rates have declined sharply for some of the more traditional asset classes. Admittedly, soaring demand has also resulted in some cap rate compression for MOBs. Cap rates of 10 percent were not uncommon in 2002, but typical MOB cap rates now tend to be in the low eight percent range - sometimes even less. An MOB in Orange County, Calif., recently sold with a cap rate of less than six percent, according to an article in Healthcare Real Estate Insights, a trade publication.

However, while MOB cap rates have been declining, yields remain highly attractive relative to alternatives. MOB cap rates are generally still about 100 to 200 basis points greater than for non-medical office buildings and other investment properties.

But there wouldn't be much of a market for MOBs if hospitals and health systems hadn't become willing sellers during the past five years.

Some observers believe that the trend began in 2001 when the government released a new interpretation of the regulations - commonly known as the Stark Laws - dealing with self-referrals by physicians. In essence, there can't be a financial relationship between physicians and hospitals if government Medicare or Medicaid reimbursements are involved. Hospitals leasing space to physician-tenants suddenly found themselves in an awkward - and potentially illegal - situation.

Below-market rents used to be commonplace for physicians in many hospital-owned MOBs, but now, at a minimum, hospitals are required to lease MOB space to doctors at market rates. Yet, even with market rents, it can be uncomfortable for hospitals to lease space to the physicians they rely on for patient referrals.

At the same time, health systems began finding it increasingly attractive to monetize non-core assets to unlock capital for expensive new services, technology and other uses.

Billions of dollars of previously unavailable medical real estate has come up for sale during the past five years as a result of the convergence of these market forces.

A Tale of Two MOBs In early 2004, Alexian Brothers Health System faced a complex challenge. The suburban Chicago provider had initiated a more than $400 million program to expand its facilities. Now it needed to incorporate convenient new medical office space to house some of those enhanced services. Yet it also had to minimize its costs. Finally, perhaps just as importantly, the new space needed to be attractive for physician recruitment and retention. After entertaining proposals from several potential development partners, Alexian Brothers selected NexCore Group, and together they crafted customized solutions resulting in two new on-campus MOBs: St. Alexius Medical Center MOB III, in Hoffman Estates, Ill., a five-story, 114,000-square-foot facility that is connected to the hospital and a two-level 380-space parking deck Alexian Brothers Medical Center MOB, in Elk Grove Village, Ill., a three-story 65,000-square-foot facility that tops a four-level, 570-space parking structure The buildings opened in late 2005, satisfying the system's need for the kind of on-campus medical office space favored by patients and physicians, while preserving Alexian's capital resources for its acute care needs. The physicians not only have new space in which to practice, but they also have an opportunity to invest in the real estate. Physicians develop a sense of ownership for the buildings in which they practice and that mind-set strengthens the hospital-physician relationship. For these projects, NexCore created a financing structure that enabled the physicians to own equity interests in the properties. Participating physicians are not just tenants or even owners of individual office condominiums; they own shares of the entire building. Rosenbloom & Saxon Surgical Specialists had an expiring lease in an off-campus building, but initially had no interest in the new St. Alexius MOB. But Dr. Bob Rosenbloom, a partner in the practice, said he was soon attracted by the new facility's quality and location and, after talking with NexCore, also became interested in investing. And with the MOB 100 percent leased to creditworthy long-term tenants like Alexian Brothers and physicians like Dr. Rosenbloom, it's also good for the NexCore-RREEF joint venture that recapitalized the property earlier this year.

Institutions Rely On JVs
Given the healthy prognosis for this market and the lack of promising alternatives, institutional investors have recently taken a closer look at medical real estate - and they like what they see. Insurance companies like Prudential and AIG; pensions funds like the California State Teachers' Retirement System (CalSTRS); and investment advisors like Heitman and JP Morgan have all warmed to the sector. Some of them have recently invested hundreds of millions of dollars in MOBs and many are actively seeking more deals.

Another sure sign that the market has arrived is that foreign investors have recently begun acquiring American healthcare real estate. Firms from Canada, Israel and Kuwait have made purchases this year - most of them for the first time - and other Middle Eastern, European and Australian investors are actively pursuing opportunities, according to their U.S.-based advisors.

Although institutions worldwide may have warmed to the idea of investing in medical real estate, some have found it difficult to enter the market. True, hospital systems have become more willing to sell MOBs. But the barriers to entry remain high - often because hospital administrators are only willing to part with real estate assets if buyers have a demonstrated record of success in working with physician-tenants.

For similar reasons, most hospital executives don't want to subject their all-important physician relationships to frequent changes in MOB ownership or management. They tend to prefer a long-term hold and, when marketing MOB portfolios, they sometimes specify a minimum holding period in requests for proposals. Flippers need not apply.

Since many institutions are newcomers to the MOB sector, they are teaming with experienced medical real estate firms to shorten the learning curve while getting an inside track on new investment opportunities. At the same time, if the institution doesn't plan a long-term hold, the continued involvement of the real estate firm can provide continuity, making a subsequent sale a non-event from a leasing and property management standpoint.

NexCore and RREEF Join Forces

U.S. healthcare spending is growing at a rate of more than seven percent per year, a driver of medical office activity. Shown here is Avista 2.

Denver-based NexCore Group and San Francisco-based real estate investment advisor RREEF recently created a joint venture that plans to recapitalize, develop and acquire about $500 million worth of MOBs during the next two to three years. NexCore and RREEF, a unit of Deutsche Bank, closed on four MOB transactions during just the first three months of their joint venture.

According to Asieh Mansour, RREEF's director of research, the aging of the Baby Boomers, increasing chronic illness among the growing senior citizen population and our increasing life expectancy suggests that we will be consuming more healthcare and consuming it for a longer period of time. All that implies that a real estate strategy that takes advantage of these powerful demographic trends should be very successful.

Nor are would-be investors likely to run out of opportunities any time soon. More than $100 billion was spent during the past five years on new healthcare facilities, according to the U.S. Census Bureau, including a record $23.7 billion last year. Industry observers say healthcare construction is likely to total from $15 billion to $25 billion annually during the next five years.

Ground was broken last year for a record 105 million square feet of new healthcare facilities, a 12 percent increase over 2004, according to McGraw-Hill, and the construction research firm is projecting a two percent increase to 107 million square feet in 2006, which would be another record.

The underlying driver of all the activity is, of course, the growth of the healthcare industry as a whole - and that also shows no signs of stopping. U.S. healthcare spending is growing at a rate of more than seven percent per year and is expected to double to about $4 trillion, or 20 percent of the Gross Domestic Product (GDP), by 2015, according to the federal Centers for Medicare and Medicaid Services (CMS). Some of the main reasons for the construction boom are Sun Belt and suburban population growth, the aging of the Baby Boomers, a continuing shift to outpatient care and the need to replace antiquated facilities.

Consequently, institutions have come to realize that MOBs affiliated with strong health systems and leased to successful physician groups are a relatively low-risk, high-return investment.

Peter Kloepfer is senior managing director for Denver-based NexCore Group, a medical and mixed-use real estate firm with projects and properties in several states.

Peter Kloepfer is senior managing director for Denver-based NexCore Group, a medical and mixed-use real estate firm with projects and properties in several states.

For more information
NexCore
www.Nexcoregroup.com