COVER STORY, MARCH 2011

IS THERE A DOCTOR ON THE PROPERTY?
Healthcare reform may bring uncertainty to the medical office market, but there are many reasons for optimism.
By Jaime Lackey

At the end of 2010, Jones Lang LaSalle arranged the sale of the 211,000-square-foot Northeastern Hospital in Philadelphia to a private investor/developer for $7.5 million.

The uncertainty surrounding healthcare reform debate is both good and bad for the medical office market. On the one hand, uncertainty breeds indecision. Simply because there is uncertainty about the future of healthcare, some planned medical office developments are likely to languish on the drawing boards despite demand, says Edward Midgley, senior vice president with CB Richard Ellis’ New York office.

On the other hand, Midgley notes, lack of development means that existing medical office space will enjoy continued limited supply. And if changes to the healthcare system result in increased demand, existing buildings will benefit.

The uncertainty is also affecting lease terms, says Tim Rorick, senior managing director with Colliers’ Stamford, Connecticut, office. “Historically doctors have signed very long leases. Now some practices are asking for 1-, 3-, and 5-year deals because of the uncertainty surrounding healthcare reform.” Rorick explains that doctors that rely heavily on insurance actually have very little control over what they get paid and they are worried about how healthcare reform will affect the financial sustainability of their practices.

Doctors that specialize in elective procedures such as cosmetic surgery or fertility are less likely to be affected by changes in healthcare policy but they are still concerned, he says.

Shorter leases are not yet widespread, though. Many doctors are still signing 10-year leases, and landlords like the stability of doctors as tenants, says Jeffrey Prezant, director with the East Rutherford, New Jersey, office of Cushman & Wakefield. “Doctors just don't pick up and go as other types of tenants might. Landlords like the stability that these tenants give their buildings; they like the fact that the spaces tend to be higher end, more expensive. And landlords are investing more in the spaces to keep doctors’ overall costs down,” he notes. Hospital Anchors in the City & Suburbs

While the healthcare debate unfolds, hospitals continue to be the catalysts for medical office space in several ways. Traditionally, medical office space has clustered in urban areas immediately adjacent to hospitals — and there is still strong demand for this space. “The hospitals are the anchors and medical offices will continue to grow around hospitals as a means of maintaining continuity with patients,” says Prezant.

However, Prezant notes, “Many doctors are now migrating between multiple hospitals, having privileges at two or three hospitals, and they are looking for well-located offices in between those hospitals. This is why Paramus, New Jersey, has been a good location for doctors, because it is centrally located between Hackensack University Medical Center and Valley Hospital. So Route 17 has become a good destination location for medical professionals.”

Many hospitals in the Northeast are also driving new medical office clusters by developing satellite campuses or ambulatory surgical centers in suburban areas, according to John Washlick, an attorney and co-chair of Cozen O’Connor’s Health Law Practice Group. Some examples of hospitals that are building or have recently built suburban clinical offices include Hospital University of Pennsylvania (HUP); Camden, New Jersey-based Cooper University Hospital; and Children’s Hospital of Philadelphia (CHOP). Many of these offices include multi-specialty practices. Even specialty hospitals like Wills Eye Hospital have opened outpatient offices in surrounding suburbs.

Proximity to hospitals is the major factor driving tenant decisions as well as investor interest in medical office space — and both groups pay a premium for location. For example, Peter Farnum, partner at FHO Partners in Boston, recently represented a medical imaging company in its search for a Boston space. The company wanted to find space with lease rates better than the renewal rate of $50 per square foot NNN at the company’s existing space. Farnum located several opportunities within 1 mile of the existing location, including one space that offered $30 gross rent with $25 per rentable square foot tenant improvement allowance for a 5-year lease term. The tenant decided its location in the heart of the Longwood Medical area was worth the premium and stuck with the $50 per square foot NNN rent with $5 per square foot in tenant improvements. (For investment sales information, see regional sidebars.)

While proximity to hospitals is key for the success of many medical buildings, landlords have a few tricks to make less perfectly located buildings more attractive. For example, complementary tenant groups can attract each other. An orthopedic practice might pay a premium to be located next to an image diagnostic center or a pediatrician might be more interested in a property that also houses a pharmacy as a convenience to patients, Midgley notes. Wellness centers — for example, those that offer adjunct services like massage and acupuncture — are also looking for higher quality finishes than found at traditional medical office spaces, Rorick notes.



The numbers also speak to tenants. Rorick says, “When proximity to a hospital is not the major factor in the tenant’s decision-making process, rent, free rent, and other traditional landlord concessions become the important factors. At that point, it becomes a business decision based largely on the numbers associated with the deal."

What is New with Medical Office Space?

Medical office was historically a very niche business with a small group of players, says Doug Rodio, vice president of capital markets with Jones Lang LaSalle’s Philadelphia office. “That is no longer the case,” he notes. “We have a much wider audience of potential buyers for medical buildings that we are marketing for sale. Medical office is a highly sought after asset class by traditional investors and a favored asset class for institutional investors, high net worth individuals and even pension funds. It is not uncommon for us to receive over 100 confidentiality agreements for medical buildings that we are marketing for sale today.”

Washlick, who represents a variety of hospitals, physicians and healthcare organizations, says there is a lot of opportunity for real estate investors in the medical office market because the industry is growing. He says, “There is significant funding earmarked for healthcare under the recent healthcare reform act. Compound that with the fact that the baby-boomer generation is healthier than their ancestors and they are projected to live longer so they will need more medical care and more convenient access to that care. There is also growing attention to individual wellness. In the past, insurance payors reimbursed doctors strictly for treating illnesses and existing health problems. Today, doctors are being reimbursed for preventative care and participating in wellness programs and individuals are being rewarded for participating in such programs, with discounted premiums and other incentives. All of this is driving the demand for medical services up and the need to bring those services closer to the individual consumer.”

If healthcare reform survives the legal challenges, Rodio says, “There will be more insured Americans, which will increase demand for medical office space. With the industry standard of 1.9 square feet of medical office space demand for each outpatient brought into the system, nearly 60 million square feet of new medical office supply could be built in the coming years. There will be an expansion of community health departments, and the demand for primary care physicians will increase. It is estimated that an additional 16,500 practitioners would be required to meet the needs of 65 million Americans that live in communities where they cannot access primary healthcare.”

However, this space is expensive. According to Rorick, the cost to build out medical office space is at least three times greater than the cost to build out regular office space. Plumbing is of the biggest cost factors in medical office, since most types of medical practices require a sink in each patient room. Once the healthcare debate is settled, developers will still need to overcome obstacles in the form of construction and land costs. In the meantime, developers, medical tenants and landlords are watching to see how changes in healthcare reform will affect the medical office market in the long term.

Medical Practices Build Their Own Projects and Buy Condos Big Sky Enterprises is building a two-story, 14,000-square-foot medical office building for developer and owner The Tuckerton Group. While many healthcare practices look to rent — especially in dense urban areas where owning is cost prohibitive — there are some doctors that want to own their own real estate. Here are two examples of projects that meet their needs: Big Sky Enterprises is building a two-story, 14,000-square-foot medical office building (above) for developer and owner The Tuckerton Group. The Tuckerton Group principals are an orthodontist and a pediatrician, who plan to occupy two of the four units at the project, which is located at 975 Tuckerton Road in Evesham, New Jersey. The project is slated for completion in September. Big Sky Enterprises is serving as general contractor and overseeing the design and approval process. Alexander Summer LLC has repositioned 2 Sears Drive in Paramus, New Jersey, for medical condos (above). Alexander Summer LLC has repositioned 2 Sears Drive in Paramus, New Jersey, for medical condos. “Even in this tough market, well-located properties will retain value, but the difficult challenge has been in filling vacancy. The New Jersey office market has not seen any new material job growth, and indecision reigns. However, we have found that medical users are frequently in the market looking to own smaller, but modern and well-located facilities with ample parking. Such properties really don’t exist which is why we decided to convert 2 Sears to a condo ownership structure so that medical practices could enjoy the benefits of ownership, and satisfy their difficult occupancy needs. The building’s proximity to the Valley Hospital, and its accessibility gave us the confidence that it would be a good location under almost any market condition,” says Alexander von Summer III, managing partner of Alexander Summer LLC. The property was constructed in 1987 and each condo has been upgraded with new wall coverings, carpeting, lighting and new ceiling tiles. Currently there are five condos for sale, ranging from 1,056 to 5,456 square feet. According to Summer, “The changes in healthcare legislation have made it even more important for medical practices to be able to control their expenses, and ownership insulates them from changes in the rental markets and makes available other tax incentives that are only available through ownership.” — Jaime Lackey

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