FEATURE ARTICLE, OCTOBER 2006

A HEALTHY INVESTMENT
Medical office properties are nice investments in the long run.
Mike Welty

Welty

Special Use 

By its nature, medical office space is inherently inflexible compared to its general office counterparts. Reception and business office areas are significantly larger, much of the space is cut up into small exam or procedure rooms and traditional executive offices are small and kept to a minimum. Typically tenants require more plumbing in their space and the electrical infrastructure required to power diagnostic or treatment equipment is generally much greater as well.

Costly Construction

The costs to build additional walls, plumbing capability, electrical requirements, higher floor load capacities and increased parking, typically result in construction costs ranging from $125 to $175 per square foot depending on whether the land was purchased or leased. Available land on or next to a well established hospital campus can be extremely limited and mirrors the costs of a typical infill location. Construction over existing facilities and/or the cost of structured parking can push these costs north of $200 per square foot. Tenant finish costs for first generation, Class A medical space start at $30 to $35 per square foot and, depending of the nature of the practice, could easily double those numbers.   

Hospital Environment

Although a hospital campus is the most logical place for medical office space, this can present a variety of problems for both investors and lenders. Through deed restrictions or a leasehold instrument, the hospital will always impose restrictions on the operation and disposition of the project. Certain tenant activities, either those that compete with similar hospital operations or conflict with its community mission statement, will be prohibited or sharply curtailed. Additionally, a sale of the property will generally require varying levels of approval by the hospital even if the property has been taken back by the investor/lender. These restrictions are done to preserve the integrity of the hospital’s operations and to prevent competing operations from occurring on their campus. Unfortunately, they have also had the net effect of reducing the number of investors willing to pursue medical office.

So, why would someone lend or invest in a medical office building?  Stability and predictability lead the list. All of the previously mentioned issues can create significant barriers to entry. Limited land availability on campuses and high costs associated with special purpose construction make this property type more difficult to produce. These issues, along with several other factors, result in occupancies in excess of 90 percent and in many cases more than 95 percent for campus based medical office buildings.  Physicians who are lucky enough to find second generation space often take it in an as is condition or receive very little tenant finish capital from the owner, requiring a personal investment in their space. Unique to the medical office building is the importance of referral patterns derived from the occupying physicians. The comparison to a successful retail center can be made in, that a proper mix of tenants can be critical to a physician’s practice. Tightness of space, physician investment in their space and lucrative referral patterns also result in a very low turn over of space, typically less than 10 percent during a 10-year period.

Near and dear to all investors, is the subject of returns. High initial costs may yield lower returns compared to other property types, but the consistently higher occupancies and low turn over in tenancy pay big dividends in the long run. Owners can typically push rents $2 to $6 per square foot higher than general office in the same market. Expenses are typically stopped or passed thru to the tenants and rents are generally increased on an annual basis Many medical office buildings have pay parking, even in suburban locations, which can significantly add to the bottom line. These economics, combined with not having to re-tenant space every 3 to 5 years, quite often will produce excellent annual returns and pay back all equity capital within the first 10 years. Although the ability to operate and dispose of the property may not be as flexible as other property types due to varying levels of hospital restrictions or approvals, this level of restriction also can be double-edged sword for the hospital. The hospital needs a successful medical office building on its campus that is contributing to the overall mission of the hospital and its physicians. Since the office building represents a major source of business, quite often the hospital is the first entity to step up to cure a problem or even purchase the building to keep it out of trouble.

What does the future hold for medical office building investment?  While everyone is concerned about the rising cost of healthcare, physicians will always need a place to dispense healthcare. Healthcare is one of the fastest growing segments of the U.S. economy representing more than 15 percent of our GDP. The aging baby boomer generation is expected to increase that percentage dramatically. Demand for new, technologically advanced buildings will only increase. In spite of continuing changes in healthcare coverage, no other industry is as heavily subsidized by private insurance, government programs or charitable activities, thereby providing a substantial source of capital. Finally, hospitals have discovered that they could re-deploy significant amounts of capital from real estate assets and still control their campus environment by selling their buildings with use restrictions as previously mentioned. This has presented long term investors with a great opportunity to invest in stable, high quality real estate with predictable returns. The future of campus based medical office looks healthy.

Mike Welty has arranged project capital for more than 70 healthcare projects and is a principal in the Atlanta office of iCap Realty Advisors, a national mortgage banking company.

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