COVER STORY, MAY 2012

TAKE TWO ASPIRIN AND CALL YOUR BROKER
The evolution of the healthcare industry is causing a shift in requirements for medical real estate.
Jaime Lackey

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.

“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 by investors that understand the strategy of hospitals. However, off-campus facilities do need to be ‘anchored’ by hospital systems or a major physician practice in order to attract investor interest.”

Trends in Medical Office Space

Co-tenancy has always been important for the success of medical space, Bodnar notes. “Medical providers depend on one another for referrals. For example, an orthopedic surgeon is dependent on a primary care doctor 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.”

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.”

In January, Ackerman & Co. sold the 30,000-square-foot Camp Creek III building in the South Fulton County area of metro Atlanta to Healthcare Trust of America for $8.9 million, or $292 per square foot — a record price for an off-campus Atlanta medical office building in this economy. Ackerman & Co. is on track to develop Camp Creek IV later this year.

John Willig, principal with Atlanta-based Ackerman Medical, the healthcare division of Ackerman & Co., notes that some medical tenants think it will be cost effective to reduce square footage. “But when they try to cram more rooms into smaller spaces, the buildout costs per square foot increase. This means the physicians are paying more out of pocket or searching for turnkey space,” he says. “And long term, a smaller space can reduce the number of patients that a practice can accommodate, which is self-defeating.”

More often than not, medical spaces need to accommodate 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.”

While physician practices are moving toward larger spaces, there is also a trend toward moving support personnel and resources to different locations to cut costs. Healthcare providers are centralizing their supply chain, data centers, or other components of their businesses to drive costs out of the system, Perman says.

“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 resources,” he says.

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,” says Jeffrey Cooper, executive managing director of Savills LLC. “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.”

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

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,” Cooper says. “In fact, a few years ago 60 percent of all hospital procedures were inpatient. We are moving toward 40 percent inpatient procedures today.”

He adds, “We are seeing far fewer new bed towers. In some cases, we are seeing a reduction in beds at existing hospitals. However, we are seeing requirements for new ambulatory surgery centers.”

The increasing focus on whole patient care and wellness is also driving new trends in real estate. “Health systems want to help people stay healthy and help patients manage chronic conditions. In some cases, health systems are adding wellness plazas to better service their communities,” says Donna Jarmusz, senior vice president for Business Development & Strategic Initiatives of Alter+Care, a division of Skokie, Illinois-based Alter Group.

A membership-based community health and wellness center can offer fitness equipment, lap and therapy pools, an indoor track, a heart-healthy café, disease management programs, and rehabilitation services. “It completes the hospital’s continuum of care and will assist in developing more positive outcomes for which healthcare providers will receive higher reimbursements,” Jarmusz says.

Alter+Care is developing the Wellness Plaza at Florida Hospital Wesley Chapel adjacent to a new 80-bed hospital in Wesley Chapel, Florida.

Alter+Care is currently developing the Wellness Plaza at Florida Hospital Wesley Chapel. The three-story, 100,000-square-foot facility is located adjacent to the new 80-bed Florida Hospital Wesley Chapel in Wesley Chapel, Florida. Approximately half of the building will offer health and wellness services to the community. Physician offices and clinical services will occupy the other half of the building. Alter+Care, which has developed 16 wellness centers, offers a turnkey development solution — from business planning to developing the facility as well as creating the operations for the health and wellness center such as hiring staff, and installing software and furniture, fixtures and equipment. Once the business is established, it is owned and operated by the hospital in real estate leased from Alter+Care.

Who Has the Advantage?

Today’s healthcare sector is definitely a seller’s market. Investment activity in the medical office sector is back at 2007 levels in terms of capital markets, Perman says.

Ackerman & Co. is developing a 60,000-square-foot medical office building on the campus of Piedmont Henry Hospital in Stockbridge, Georgia.

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.”

Private investors will be involved in the majority of transactions this year, but REITs and institutions will account for the greatest share of dollar volume as they target on-campus assets and top-quality off-campus buildings affiliated with health systems, according to Pontius. “Following a late-2010 surge in acquisitions, REITs and institutional investors reduced their pace in 2011. However, they re-emerged with vigor in the third quarter of 2011 and ultimately accounted for 45 percent of total volume for the year,” he says.

One such institution was Griffin-American Healthcare REIT II, which acquired 117,000 square feet of medical office properties in Florida, Georgia and South Carolina for $25.1 million in a transaction arranged by John Smelter, senior director of Marcus & Millichap’s Healthcare Real Estate Group.

The properties are located on hospital campuses or close to regional medical centers. In the Atlanta metro, the California-based investment group acquired the East-West Medical Office Building, a one-story, 42,000-square-foot structure developed in 1999 in Austell. Ortholink Physicians Corp. occupies 79 percent of the fully leased asset, which is half of a mile from 382-bed WellStar Cobb Hospital. In South Carolina, Griffin-American Healthcare REIT II acquired the 47,000-square-foot Okatie Medical Office Building. The three-story building, delivered in 1997, is 91 percent leased to a trio of tenants, with Hilton Head Regional Healthcare System in 82 percent of the medical space. The Florida purchase is the 28,000-square-foot Boynton East Medical Office Building, developed in 2003 on the campus of the 400-bed Bethesda Memorial Hospital in Boynton Beach. Bethesda Memorial is the largest of the eight tenants, occupying more than 46 percent of the 95 percent-leased two-story building.

In a separate transaction, Smelter arranged the sale of Emerson Medical Plaza Building 2, a 34,000-square-foot medical office building in Jacksonville, Florida. The sales price of $13.26 million equates to $390 per rentable square foot. Smelter represented the seller, Emerson MOB II LLC. Emerson MOB II LLC is a partnership between ABR Chesapeake III, a value-added real estate investment fund sponsored by Baltimore-based Alex Brown Realty Inc. and Health America Realty Group LLC. The property was acquired by HSRE – Emerson LLC.

“Emerson Medical Plaza Building 2 is the newest building located at the Emerson Medical Plaza,” Smelter says. “Emerson Medical Plaza is an outpatient satellite campus that includes an ambulatory surgery center and one other medical office building. Emerson Medical Plaza Building 2 is 100 percent leased to Shands Jacksonville Medical Center, which is affiliated with the University of Florida,” adds Smelter. There are more than 10 years remaining on the lease.

On the tenant side, we are also seeing some 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?

Although the recession did negatively impact the healthcare real estate sector, more fundamental issues within the healthcare industry will drive greater changes in the future. “The nature of healthcare reimbursements is evolving,” Willig says. “The focus is turning to patient outcomes and wellness rather than rewarding volumes of procedures. This is causing a re-alignment in the industry. Healthcare systems will lead the change as they reposition over the next decade, but in the near term the whole industry is under assault from the recession and uncertainty about reform and how it will affect reimbursements. The challenge today — for real estate owners, developers, and healthcare companies — is to choose real estate opportunities carefully and to mitigate risk.”

As with all property types today, investment requires substantial equity and satisfaction of strict underwriting criteria, Willig says. “Most distressed medical properties for sale are coming to market through lenders and special servicers. They require all cash and must close immediately. For example, we just purchased the 62,000-square-foot Winn Medical Center next to DeKalb Medical hospital in Decatur, Georgia. We closed on the $3.67 million transaction in 3 days,” he notes.

In the Southeast, vacancy dropped 40 basis points in 2011 to end the year at about 9.9 percent, whereas the national vacancy dropped 30 basis points to 11.3 percent, Pontius reports. Although he 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 healthcare sector will continue to fare well despite the uncertainty. “Healthcare is an 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.

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

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.”

©2012 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.