COVER STORY, JANUARY-FEBRUARY 2012

A PRESCRIPTION FOR CHANGE
The evolution of healthcare is causing a shift in requirements for medical office and healthcare space.
By Jaime Lackey

The 146-bed, $350 million Einstein Medical Center Montgomery in East Norriton Township, Pennsylvania, will open in September. The facility is the first new hospital in southeast Pennsylvania in more than a decade. The new campus consists of 84 acres and will include a 75,000-square-foot medical office, which can be expanded in the future.

Healthcare providers are making real estate decisions by weighing revenue projections (based on declining margins) against marketing decisions. Even as insurance reimbursements decline, hospitals and physician groups are changing business strategies to attract patients and compete for market share.

“Patients have choices,” says Al Pontius, managing director of the Healthcare Real Estate Group with Marcus & Millichap. “Hospitals and other medical providers want to be the nicest, most convenient and most cost-effective option. Therefore, they market to the patient and this comes into play when they make real estate decisions.”

For example, many hospitals are opening outpatient (ambulatory) emergency rooms and clinics near patients, says Todd Perman, senior vice president and national director of Grubb & Ellis’ Healthcare Properties Group. These satellite locations make the hospital systems more convenient to patients at the point of care.

Similarly, many hospitals now want to directly employ primary care physicians in order to control a larger patient base and therefore more referrals. In fact, many hospitals are “deploying” primary care physicians into communities with strong demographics, says Chris Bodnar, national co-leader of the CBRE Healthcare Capital Markets Group.

Chris Bodnar, national co-leader of the CBRE Healthcare Capital Markets Group

“Some healthcare providers are looking at vacancies in retail centers as well as more traditional off-campus locations,” Bodnar notes. “Primary care, urgent care and clinics that provide services like dialysis don’t need to be on a hospital campus.”

Pontius says that investors in the medical office space see the value in these non-traditional locations. He explains, “All other things being equal, investors and lenders have traditionally preferred on-campus buildings. Today, major systems are pushing community outreach programs and opening satellite offices to make healthcare options more convenient for consumers. We are now seeing more development off campus and these facilities are perceived as less risky as investors understand the strategy of hospitals. However, off-campus facilities do need to be ‘anchored’ by hospital systems or major physician practices in order to attract investor interest.”

Trends in Medical Office Space

Doug Rodio, vice president, Capital Markets, Jones Lang LaSalle

“Cost control is paramount,” notes Doug Rodio, vice president with the Capital Markets group in Jones Lang LaSalle’s Philadelphia office. “Instead of ground-up development, I believe we will see more renovation and repositioning of existing assets. More co-location of multiple providers for coordination of care is coming too.”

Bodnar agrees: “Medical providers depend on one another for referrals. For example, an orthopedic surgeon is dependent on a primary care doc for referrals; likewise, a physical therapist is dependent on the orthopedic surgeon for referrals. It’s like putting a puzzle together. Once all of the pieces fit together, it’s easy to predict the stability of the tenancy. The investor community likes seeing this type of symbiotic relationship among tenants. It’s all about stability.”

The requirements of the Affordable Care Act will have a material effect on healthcare real estate, according to Jeffrey Cooper, executive managing director of Savills LLC. “The act calls for the establishment of Accountable Care Organizations, which merge the ambulatory primary care function with multi-specialty, hospital and rehabilitation functions to achieve coordinated and cost-effective patient treatment. This delivery model will ultimately require medical services to be housed within close proximity to each other such as in a single ambulatory building allowing for coordinated delivery of healthcare.”

Creative solutions such as shared waiting rooms can also decrease costs. For example, a 186,000-square-foot building near Syracuse, New York, has been converted from traditional office use to medical use. The 20-year-old facility featured a very large common area. According to Perman, his client (the ownership group) added wi-fi and created an integrated waiting room so that patients of all the tenant practices sit in the common space while waiting to be called. They wait for buzzers to sound, just like the system used at many restaurants.

Todd Perman, SVP and national director of Grubb & Ellis’ Healthcare Properties Group

“This amenity has helped the landlord generate leasing activity since the medical tenants don’t have to pay for waiting areas within their premises, thereby reducing rent costs by as much as 15 percent. In just one year from when the previous corporate owner vacated the premises, the ownership has been able to re-tenant 95 percent of the building with quality medical tenants,” Perman notes.

Healthcare providers are also implementing creative solutions to cut costs such as centralizing their supply chain, data centers, or other components of their business to drive costs out of the system, according to Perman.

“The three largest costs of most practices and healthcare systems are labor, supplies, and real estate. You cannot eliminate any of the three, however, taking a creative approach by streamlining the delivery of those resources is critical to the providers' ability to treat more patients more efficiently so that they can thrive in the changing healthcare environment. All of this involves real estate including centralized data centers, warehouses, and strategic location and allocation of their resources,” he says.

Building obsolescence is a concern in the medical office sector. “Medical tenants will not locate in a ‘dumb’ building,” says Pontius. “Buildings must be fully equipped with IT to access electronic medical records at the hospital.”

Buildings also need to work for larger practices, which are becoming the norm. There is a trend of small physician practices being acquired by larger physician groups. Larger practices operate more efficiently and benefit from more patients feeding into their system. As these practices grow, they require larger blocks of space, Perman says. “What are building owners supposed to do with the existing [small] blocks of space? As smaller practices are being absorbed, building configurations must change. Smart landlords are being proactive.”

Development of Healthcare Space

“If the individual mandate requirement in the Patient Protection Act is not overturned by the Supreme Court, an estimated 30 million patients will have access to non-emergency care,” Cooper says. “Those patients will be able to seek treatment and preventative care from primary care physicians in ambulatory facilities — assuming there are enough doctors. This increases the demand for medical office and ambulatory space.”

Al Pontius, managing director, Healthcare Real Estate Group, Marcus & Millichap

Even if the Patient Protection Act is declared unconstitutional, “demographic forces suggest an expansion of healthcare is needed to care for the growing 55+ population,” says Pontius.

Based on the projections for numbers of patients coming into the system, there is a need for development, says Bodnar. “However, the environment of decreasing margins makes healthcare providers extremely capital sensitive.”

But money isn’t the only deciding factor. Changes in medical procedures themselves are changing the demand for different types of real estate.

“As medical procedures become less invasive and as inpatient reimbursements decrease, more and more procedures are being done on an outpatient basis, so we are seeing more demand for outpatient facilities and less demand for inpatient facilities,” says Cooper. “In fact, just 1 year ago, 60 percent of all hospital procedures were inpatient. We are moving toward 40 percent inpatient procedures today.”

Jeffrey Cooper, executive managing director of Savills LLC

He adds, “We are seeing far fewer new bed towers. In some cases, we are seeing a reduction in beds at existing hospitals. For example, NYU Medical Center is taking two-bed rooms and converting them to single-patient rooms. However, we are seeing requirements for new ambulatory surgery centers.”

According to Rodio, “Speculative development is still really slow. A development opportunity with strong sponsorship and pre-leasing of at least 75 percent is doable in today’s market. Healthcare systems and large doctors’ groups can find capital for projects they plan to occupy.”

Who Has the Advantage?

Investment activity in the medical office sector is back at 2007 levels in terms of capital markets, Perman says.

He adds, “Private and public REITs have raised $22 billion to invest in medical office and other healthcare-related properties in the last couple of years. Transaction volume in 2011 was approximately $1.5 billion. That leaves a tremendous amount of capital looking to acquire a short supply of quality assets. This is causing cap rates to compress and pushing sellers to approach the market. In fact, medical office values are already at 2007 levels — no other sector has done that.”

Several publicly traded REITs are looking to expand their medical space holdings in the Northeast, says Bodnar. Specifically, he notes that Florida-based ProMed Properties recently opened a Manhattan office in order to better follow the market and seek investment opportunities. The company recently purchased two buildings totaling 252,000 square feet in Boston. Bodnar also notes that Grosvenor in Philadelphia has raised $600 million in Middle Eastern money and Harrison Street in Chicago has a new core fund to invest in trophy medical office space.

It is a seller’s market. Tenants are also seeing continued opportunity. “Landlords are very focused on tenant retention, and as a result, we are still seeing a bit of rent compression and landlords are willing to consider reasonable concessions,” Perman says. “On average, tenants will get $5 per square foot per lease year in tenant allowances. That usually totals $50 to $75 per square foot. But the tenant will likely spend more than $100 per square foot on buildout.”

What Will 2012 Bring?

While medical office space is generally very stable across the nation, the Northeast has fared better than the nation, according to Pontius. In the Northeast, vacancy dropped 80 basis points in 2011 to end the year at about 10.5 percent, whereas the national vacancy dropped 30 basis points to 11.3 percent.

Although Pontius notes that leasing activity is picking up, he says, “It is still not robust because there continues to be a lot of caution on the provider side.”

The sector will continue to fare well despite the uncertainty. “Healthcare is a evolution, not a revolution. Even though there will be changes and cutbacks, there will be a huge influx of new patients which means the outlook is extremely positive,” says Perman.

However, questions about healthcare reform will continue to inhibit activity in the sector in the near term, says Pontius. “Who will have insurance? What will reimbursements be? There will be downward pressure on reimbursements for a while. Physicians find it a challenge to make decisions when they cannot accurately predict pending changes to the rules of the game.”

Rodio predicts, “Healthcare systems and large physicians groups will develop new strategies to take advantage of healthcare reform as best they can. 2012 could be the year for some to finally take advantage of pent-up investor demand with sale-leaseback offerings, as pricing for those types of deals is still extremely aggressive.”

“Healthcare is a trillion dollar business,” Perman notes. There is money to be saved by carefully examining space needs in a changing industry.

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