by Michael Bennett, Managing Director, HFF
The market for medical office real estate (MOB) has changed dramatically during the last few years. Once a fringe product type, MOB is inching towards the spotlight as a main-stream real estate investment. The space, once dominated by a handful of healthcare REIT’s, has expanded. Cap rates, once routinely double digit, are now sub 5 percent in some cases. Capital wants to be in this space; with more than $9 billion in equity raised in 2014 specifically for the pursuit of MOB. What is driving this?
The basic attributes of medical office real estate are a big factor in why investors are attracted to the space. Landlords leasing space to physicians and hospitals leasing space have a high rate of retention. Renewal percentages can average up to 90 percent. The locations are typically “needs based” not only from the patient side, but also from the hospital’s need to move services off their campus. This is what we refer to as “strategic” when talking about healthcare real estate – the hospitals have a vested interest in the MOB. Furthermore, barriers to entry such as complexity, higher costs, obtaining a certificate of need (in some states) and the general desire of tenants wanting to be near the hospital where land is at a premium, limit the amount of MOB’s being built. The ACA (Affordable Care Act, commonly referred to as “Obamacare”) and the 30 million new Americans that have healthcare can’t be ignored either. These new patients, coupled with the 8,000 to 10,000 “Baby Boomers” turning 65 every day, create a demographic title wave (coined by some to be the “Silver Tsunami”) that we can’t get away from. This demand will continue to drive need for these facilities.
Cap rates have compressed to record levels. There is a lack of supply, and although there will be more deliveries for new product this year, it won’t be enough to satisfy the demand. As mentioned earlier last year there was approximately $9 billion in equity for what ended up being approximately $5.5 billion in transactions. The lack of product caused cap rates on MOB’s on-campus and leased to a credit-rated tenant, or large physician group with strong financials to crest just below a 5 percent cap rate; while strategic off-campus MOB’s, traded in the 6 to 6.75 percent range. I’d be remiss not to mention the cost of capital as a component of low cap rates. The 10-year treasury is near a historical low point. The narrowing spread over the 10-year for fixed-rate debt, or a floating-rate over LIBOR, allows increasingly more investors to compete for assets at lower cap rates while maintaining positive leverage and cash flow. REIT’s have an even lower cost of capital, and several ways to tap it. Most REIT’s have a line of credit (credit facility or credit line) with big banks. Today those rates are in the mid to high 2 percent range. They can also issue stock for large chunks of money, or use an ATM (at-the-market) to raise money in smaller size, but in more regular (daily) increments.
The pool of investors is much wider and deeper. We often receive more than 30 confidentiality agreements and 10+ offers on our marketed properties. Private equity groups like Harrison Street, MB Real Estate, and Stage to name a few, are competing against incumbent REIT’s and often winning. Further crowding the space are non-traded REIT’s which have raised billions of dollars for the acquisition of healthcare assets. Carter Validus, ARC, and AHI are among the most active. Two of these non-traded REIT’s, ARC and AHI, have recently completed more than $6 billion in portfolio sales to larger REIT’s. This capital, in addition to the other billions they have raised will be re-deployed back into the acquisition of healthcare real estate. As if the space was not crowded enough, developers are even getting in to the acquisition game. Hammes, a large developer in Milwaukee has closed on more than $250 million in the last 24 months for the pursuit of JV developments and pure acquisitions.
However, the juxtaposition of all this growth is that the space is consolidating. Not the size of healthcare real estate, or capital, or need, but on one major front: the number of healthcare systems. The ACA has unleashed a fury of M&A activity as hospitals scramble to shore up costs, improve operations and set up ACA’s. Independent physician groups are being acquired by large systems. And less efficient hospitals that have a desirable market share are big candidates for acquisition. M&A activity hit a five-year high in 2013. Health systems already control 85 percent of the medical real estate in the market. Time will tell whether the consolidation of systems will expand or contract the opportunities to own strategic healthcare real estate.
“Retailization of Healthcare”, which is the mindset of large systems, is very much a retail strategy. Go to where the patient lives and works. Gain mind and market share through an out-patient ambulatory strategy or acquisition and re-branding, and have a presence in those communities to provide services outside of your main hospital campus. This saves on cost for the hospital, but has the added benefit of squeezing out completion. These out-patient facilities are usually developed by third parties on a BTS basis, and have been a big part of the rapid growth of healthcare real estate transactions.
Medical office buildings will remain highly attractive due to their hospital tenancy, need-based macroeconomics, aging population, newly insured off-campus strategy of the hospitals, and the barriers to entry for development. Cap rates will remain low until interest rates begin to tick up significantly, and investors will continue to pile new capital into the space.
Michael Bennett is a Managing Director with HFF in Chicago. He co-leads the MOB Capital Markets Group with Phil Mahler, Jack Dudick and Evan Kovac. The team is currently in the market with more than $1 billion in available medical real estate equity, and sale opportunities, including the largest hospital system monetization of the last 10 years, the largest single asset MOB to sell on record, and several $50M+ portfolios. Contact HFF at 312.528.3694.
