Changing Drivers of Healthcare Real Estate

Spring 2011
The Mary Catherine Bunting Center, an addition to Baltimore’s Mercy Medical

Medical services are striving to become more customer-friendly, efficient and cost effective, not only in recognition of the coming wave of aging Baby Boomers, but also in response to major healthcare cost and operational challenges. Healthcare providers are also driven by the imperative to maintain and build branding and market share in a highly competitive environment.

Not surprisingly, real estate is playing a critical role in the healthcare industry’s evolution. Healthcare real estate practitioners liken current trends to “town center”-style retail development and to the hospitality industry’s quest to cultivate a loyal clientele.

Whether facilities are located on a hospital campus or off – decentralization of services is a key trend -- their design reflects the providers’ mission to make healthcare more easily accessible, affordable, safe and efficient, with more of an emphasis on outpatient care. Increasingly, these facilities are also being designed to foster a continuum of care, incorporating wellness for all age groups.

Though clearly a real estate opportunity, healthcare real estate development is not for the novice or the faint of heart. Working with hospitals, for example, involves a very different kind of decision-making process and financing challenges than conventional development; patience and deep pockets are required to navigate that process, which can often lead to a gap of several years between initial plans and construction.

Doing Nothing Is Going Backward

Gregory Chang, principal and managing director, Healthcare, at Ellerbe Becket, an AECOM Company, re­marked that the challenge for healthcare is both inside and outside the hospital setting: creating a continuum of care, including wellness, research and home care for an aging population.

Hospitals have a 50+ year life span, Chang pointed out. “They are living, breathing facilities, with engagement in the community,” he said. Working with older models is especially challenging now because of the aging population. A hospital can expand, renovate or add space to enhance what it already has; or it can take an operational approach with better management for more efficient flow.

Holy Family hospital

Hospitals are diversifying services and creating healthcare destinations that resemble retail town centers to provide a one-stop healthcare experience.

An example of expansion is the 120,000-square-foot bed tower ad­dition to Mary Washington Hospital in Fredericksburg, Va., a five-story, 100-bed facility. It features a consolidated main entrance and expanded lobby and registration areas, retail amenities and support spaces. Satellite facilities of­fer such services as mother-baby programs and urgent care. “These are easy departments to pull away” from the main campus, he said.

A lot of hospitals struggle with inherited facilities that can be large and intimidating. “Access to a facility is the make or break of any medical facility,” Chang said. For patients, it can be a struggle to get parking and navigate through a hospital to get to a provider or a service. “A lot of times, patients are older, so ‘way-finding’ should be very convenient. It should not take three hours for a patient to get an X-ray or a prescription,” he noted.

Although the impact of healthcare reform is still unclear, and some hospital systems have adopted a “wait and see” approach, Chang warned that “doing nothing is going backward.” He reported that “lately we see facilities being more ag­gressive. They’re still unsure about reform, but increasing their debt ceiling because it’s important to be positioned to accommodate baby boomers. In Florida, they’re timid about making big moves. In New York, they’re very prepared to make moves or to stay with their sweet spot. People still get sick.”

It Takes a Healthcare Village

Alter+Care, a unit of the Alter Group, was a pioneer of the new model of delivering outpatient care -- the “healthcare village,” in 2005. The idea is to co-locate primary care, imaging, diagnostics, outpatient surgery and freestanding emergency departments and well­ness centers to deliver a compre­hensive continuum of care.

Its healthcare village in Manito­woc, Wis., Holy Family Memo­rial Harbor Town Campus, is an 86,000-square-foot wellness center and ambulatory care mall that integrates ambulatory services such as occupational medicine, primary care and orthopedic practices, diagnostics, a walk-in clinic, sports medicine and physical rehabilitation.

Holy Family wanted to differenti­ate itself from the competition; consolidate primary-care physi­cians’ clinics for operational cost savings; convert non-urgent emergency visits to a more cost-effective environment; and recruit additional orthopedic physicians. According to Alter+Care, in its first fiscal operational year, the finan­cial success and enhanced image positioned Holy Family Memorial as the dominant healthcare provider in its service area. The wellness center has provided a new source of positive cash flow, a fresh stream of consumers and completes the continuum of care for the hospital.

Holy Family hospital pool

The Holy Family Harbor Town Campus integrates primary care practices, diagnostics, a walk-in clinic and physical rehabilitation.

Alter+Care is involved in projects on the East coast, Midwest and Southeast. Donna Jarmusz, senior vice president for business develop­ment of Alter+Care Group, said that while providers are waiting to see how health reform legislation would affect them, toward the end of 2010 there was an upswing in capital development on their part.

Hospitals are diversifying services and creating healthcare destina­tions that are like retail town centers. “They are landlocked on campuses and want to be where people live and work. They’re trying to create an experience that’s as seamless as possible. If you need lab work and X-rays, there’s one computer system, it’s as easy as possible. Healthcare is finally learn­ing from the hospitality industry that this is how you retain clients,” she remarked.

For most of its clients, Alter+Care provides capital. “We develop, own and manage the real estate portion of the project. They don’t want to be the landlord,” noted Jarmusz. Depending on the client organiza­tion, the company may offer physi­cians an equity position.

One advantage Alter+Care has is that “we all come from health­care,” she noted. “We all were on the inside, so we know what it’s like to move forward through Board committees and the approval systems and senior management.” The company starts with a business planning process and constantly refines the plan before construc­tion, redoing budgets, making sure the plan is viable.

“All of that is done internally,” she said, adding that the company bids out construction and architectural design. It remains very flexible and entrepreneurial in order to maintain relationships for future projects and has no fixed benchmark return in mind when it tackles an assignment.

MOB Mentality

For medical office buildings (MOBs) there has been some suc­cess – and public approval – in transforming old malls or other commercial properties into medical facilities. In Hartford, for example, Hartford Hospital transformed a two-level building that was a car dealership into a new home for its Women’s Health Services unit. The move freed space from a build­ing on the hospital main campus a block away for more acute care. Mercy Health System in Baltimore turned a former grocery store into an outpatient facility.

But the costs of adaptive re-use can be too high to justify development. Jim Kornick, managing director of NorthMarq Capital, and a specialist in medical office buildings in the Mid-Atlantic region, cautioned that “adaptive re-use is overblown as a story. You’d have to buy at a pretty low basis. You need anchors that you can build tenancies upon.”

Holy Family hospital group exercise room

There is a robust market, however, for “off-campus” hospital facili­ties and suburban MOBs. Kornick reported that the firm was about to close on a 36,000-square-foot off-campus outpatient facility for a hospital, outside of Washington, D.C. The price was $300 a square foot – twice as much as it would have been for a conventional office building, he said. “We had people fighting over it, with a seven cap going in. A year earlier the same deal would have been an eight cap. Pricing is at ’07 levels,” he com­mented.

Over the past year, MOB buyers have been predominantly public and private REITs, he pointed out. “Financing has been available,” he said. “So much capital has been raised, and we expect they will continue to be the most active buyers in 2011. More will get on the bandwagon as it looks like a better ride.”

Due Diligence? Ask the Man Who Owns Some

Due diligence for healthcare facili­ties is very much about the strength of the hospital, Kornick observed. “You’re underwriting the hospital or health system -- that’s an important part of the deal. Buyers are looking for stable, predictable cash flow. The seller will choose a buyer they feel comfortable with, in operating an important part of their business.”

Prospective buyers analyze the spe­cialties the hospital is known for; management of the hospital; mix of uses in a building (the ideal is a coherent synergism); its margins; cash on hand; the number and ages of staff physicians.

“The grocery-anchored shopping center analogy is important,” he said, meaning that issues of parking, signage and synergy are key. MOBs continue to be popular investments for doctors, who are stable tenants and have a high renewal rate.

Norvin Properties is a real estate private equity fund dedicated to providing creative capital solutions to the healthcare industry; it works with healthcare operators, allowing them to profit from the value of their real estate. Norvin monetizes acute-care hospitals, ambulatory surgery centers, integrated medical facilities, outpatient treatment and diagnostic facilities and medical office buildings.

Since 2002, Norvin Properties has assembled a portfolio in excess of one million square feet. Based in New York City, it is one of the larg­est for-profit owners of healthcare properties in the huge Texas Medical Center.

“Healthcare real estate is a broad universe,” said Norman K. Livingston, managing partner and founder of the company. “If we’re buying a hospital, we’re evaluat­ing the operating company. Is it a strong credit tenant? You also look at the dynamics of the marketplace and the quality of the healthcare system.”

Regarding the differences between acquiring healthcare facilities, ver­sus conventional office space, Liv­ingston said, “When a real estate investor sells an office building, that’s the end of the relationship. When a healthcare institution sells an asset on its campus, it’s the beginning of a relationship. They’re concerned that the buyer is sensi­tive to the values and culture of the institution. Their constituency is physicians and patients who come to see them.”

He noted that last year’s healthcare reform legislation “is somewhat onerous regarding physician-owned hospitals; unless it changes, you can’t do it.” And that, of course, represented an opportunity. Livingston said that his company is known as a problem-solver, and Patients Medical Center (PMC) in Pasadena, Texas, certainly required that.

Stafford Hospital Center

Stafford Hospital Center. Photo courtesy of Don Pearse.

The 117,000-square-foot PMC opened in April 2007. It had been developed in joint venture between physicians and a developer; the developer had an interest in the operating company and an owner­ship interest in the real estate, but it was not a successful marriage. Livingston said that before a sale could take place, a settlement agreement was needed with the developer. Moreover, there were concerns about the long-term vi­ability of this specialty hospital.

Livingston discussed the po­tential benefits of bringing in a powerful partner – which turned out to be St. Luke’s Episcopal Health System. Norvin initiated and orchestrated a joint venture, through which Norvin also pur­chased PMC, which is being leased back to St. Luke’s and Patients Medical Center, and 16 acres of land. Houston-based St. Luke’s Episcopal Health System acquired 51 percent of Patients Medical Center (PMC) of Pasadena, Texas, in a transaction that expands the St. Luke’s service area and brand to the southeast Houston suburbs. Livingston likened it to a “hub and spoke” system that feeds the “mother ship.”

A Hospital’s Perspective: Doing the Math

The prestigious Children’s Hospital Boston, the pediatric teaching facility for Harvard Medical School, is a tertiary facility for critically ill children and a destination for patients from all over the world. Its primary location is in the one-square-mile Longwood Medical area.

Charles Weinstein, Esq., vice president of real estate, planning and de­velopment, provided some insight into how the hospital meets planning, financial and patient service challenges.

Children’s Hospital Boston’s annual capital budget is $225 to $250 million. Weinstein said that the hospital has been spending $1 billion every five years and expects that to continue. Projects are paid out of its capital budget, with tax exempt bonds issued covering two or three other projects. (Bonds are AA2 rated, he said.) It has a healthy endowment, the third largest in the Boston area, after Harvard and MIT, Weinstein noted. The hospital does not use third-party developers; Weinstein has a 25-person project management team, engineering staff of 90 people and a major capital project staff.

The hospital sits on 12 acres here and there is a constant need to “renew ourselves,” he said. There is new construction of a $170 million, 12-story tower under way on the Main Building, which is a lateral expansion with a footprint of less than 10,000 square feet. The tower is expected to open in early summer 2013.

“We will see 325,000 to 350,000 outpatient visits in a year,” he said. “We used to see 550,000 ambulatory visits at Longwood; 300,000 are now going to the suburbs. We’re trying to keep Longwood for the sickest kids and bring routine outpatient visits closer to where the families live.”

The hospital has been attracting some patients because “a lot of adult hospitals with 20 to 30 pediatric beds are shuttering those beds because they can’t staff them. We are the beneficiary of their volume,” he said. Patients may also be the children of patients treated in the past, with the same congenital defects. And many patients are living longer; 12 to 15 percent of patient volume is comprised of adults over age 25. MS patients whose life expectancy might have been late teens now live to 50 to 60.

“It’s not easy for a hospital to break even. The hospital has a $1.5 billion operating budget, with a two to three percent operating margin. It loses money on patient care, but it’s our mission,” noted Weinstein. Medicaid pays 50 percent of patients’ costs, while regular payers reimburse about 60 to 70 percent. The hospital’s endowment makes up the difference and “there has been a strong emphasis over the past four to five years to sig­nificantly reduce our cost of healthcare delivery. We also need to increase utilization of diagnostic equipment so we are providing greater value to our patients and their healthcare providers,” said Weinstein.

For More Information

Ellerbe Becket
NorthMarq Capital
Norvin Properties