Medical Office Performance Update

Understanding the advantages of a medical office property can provide stability to an otherwise risky real estate investment portfolio. The uniqueness of this commercial property type makes it a favorable investment, especially throughout ‘down’ economic cycles when stability, rather than overexposure, is sought to balance a portfolio. This, as evidenced by investments in 2008 and 2009, a few of the strongest years for medical office investment in decades and, notably, the worst for other commercial sectors happens to be the most recent phenomenon.

As for today, when greater threats appear to loom on the horizon and political strife sits at its highest plateau, and as office and industrial properties attract greater attention due to an improved economic position in the U.S., the healthcare sector’s investment has seen a moderate decline in volume of transactions. Most experts suggest that early-to-mid 2013 will see a resurgence of capital into the medical office property as hospitals seek to monetize real estate to offset costs associated with administrative growth, a precursor to healthcare reform.

So, depending on the current status of the property, and given a 12-month window with which to lease, redevelop or stabilize the property, the direction chosen today will likely determine if the property has the potential of resale during the next cycle.

What should you be familiar?

It starts with our research. Keen insight begins with dedicated research resources that provide for the persistent investigation into changes in physical relocation and current and future regulatory implementation. Our employed fact-finding & intelligence unit corroborates their mined data with paid, less reliable online resources and government data. While the cost of obtaining information remains high when paired to its return on investment, the overall collaboration of multiple data channels remains essential for the specialist whose clients require the most candid data for appurtenant decision-making.  So, investigation into your premises is a first step to understanding potential referral patterns and tenant mix to maximize valuation.

Second, and of greater importance to sale of the asset, the medical office opportunity should have a hospital nearby that demonstrates economic strength mainly through specialized services that provide for in-house referrals, physician growth and collaboration. Orthopedic, Cardiology, Women’s Services and Gamma Knife procedures have been lucrative hospital services and, in turn, have provided for higher effective rental structures throughout these medical office buildings. While a property will fluctuate in transacted sales price, such services attract higher capital investment because of hospital’s strength from physician services and specialties. Thus, you can see where healthcare reform, and its proposed focus on volume, rather than profitability, has the potential to water down hospital revenues and, ultimately, potential sales prices.

Another factor to consider is the area’s residential growth of the 3-mile radius. What is the rent to own ratio? Younger or older demographics? Household income? Over the past few years, investment has sought properties that provide for economic stability through employment and demographic growth. This trend will continue until it is known whether healthcare reform provides to be a viable investment alternative or an epic failure in a time of the state’s and nation’s budgetary complications. Remember, older and wealthier populations still utilize the majority of healthcare services and are more likely to see a physician out of want, rather than need, which will continue to guide investment.

When analyzing how a medical office property will/can perform, it is essential to seek guidance from a qualified professional team dedicated to the industry.  Our associates maintain years of exceptional, professional service to the Texas medical communities and with an expansive proprietary database, widely recognized as the best in the business, we hope you will seek out our firm for your medical office building needs.

This post was written by Robert S. “Bob” Lowery, Managing Partner of MREA | Medical Real Estate Advisors.

Why Our Clients Are Saying “No” To Hospital Systems

Several years ago, a partner and I undertook a major leap of faith to become exclusively intertwined with the medical industry.  With over 40 years of combined commercial real estate experience, looking back, we took some bold steps to immerse ourselves into this growing healthcare provider network.

In the beginning, we were witnessing tremendous demand from every medical network to expand ancillary service types and locales, and imaginations were certainly running wild.  We became instant beneficiaries of this growth spurt and soaked up transactional experience and a command of the tenant mix and business components that were successful for a given medical office building or hospital system.

In just a few years, with changes occurring so rapidly, so dramatically, it is now difficult to talk ‘expansion’ with using the term ‘consolidation’ in the same sentence. This is not to say that medical groups are not expanding, it continues.   As to where, you would not be surprised.

But this time, several hospital systems have been kind enough to request our perspective on the physician marketplace and their specific growth opportunities.  Ultimately, these calls begin, and circle back to, our long standing commitment to physician groups, whereby equipping them with best potential business and real estate options in the marketplace.

But, recent dialogue suggests that hospitals are having a difficult time inducing established physician groups to become part of their system.  There are several reasons, most of which revolve around healthcare reform as a general theme, but others tend to be more specific to the physicians’ professional future and their general discontent of employment.

Thus, we want to highlight the reasons some physician groups are saying “no” to hospital employment.

1. Some hospitals are at significant risk of hiring too many doctors.  With too many doctors come too many competitive pressures for doctors to perform comfortably.

a. Doctors will need to prove their worth during the contract, especially if new groups are absorbed.  The thought alone may jeopardize physician commitment.

b. Hospitals may struggle with financial issues relative to their business plans in the mid-2000’s, or with future obligations of regulatory nature.

c. Contracts may include, sometimes discreetly, clauses that pertain to early termination.

d. Sometimes Hospitals go through mergers or acquisitions of another that has the ability to affect physician relations with one or all.

2. The intricacies of how employees should be compensated by hospital systems creates an unfair advantage from one to another.

a. Hospitals have the advantage when implementing metrics to determine the highest profitability within practice endeavors.

b. RVU methods can be abruptly changed when given the uncertainty of less or greater government support.

c. Patient increases have the ability to overwhelm certain pratice areas, such as family practice, without compensation measures that adequately provide for such increases.

3. Seniority is perceived not to be an attribute within the hospital system.

a. Hospitalists have assisted in call duty challenges, but more often than not, the younger physician population is not enthusiastic about taking a tremendous call load and are voicing their concerns.

b. Hospital systems may not provide adequate measures to control call duty and patient volume, where private practices may employ these actions.

4. Physicians are accustomed to being in control of outcomes under their supervision.

a. Physician groups are quickly implemented into system and can become disenchanted in how their doctors, or staff, are being utilized.

b. Ancillary services may be a large component of a practice’s income, in which most are absorbed or non-negotiable when entering into a hospital contract.

c. With the advent of electronic health records, comes the hospital systems consumption of physician data into the coffers of a strategic, web-based marketing and patient assimilation network.

5. Non-compete clauses could take the most highly informed physician groups by surprise, especially if contracts are for a limited period of time.

a. A Hospital system made have affiliates, or may merge or acquire another hospital or network of physicians which effectively places additional limits on where a physician, or practice, may perform.

b. Upon the conclusion of a contract or severe downturn in economy, non-compete clauses can interfere with a physician, or practice group, whereas services are no longer needed and physicians may not partner or practice where they choose.

These are just a few of basic issues that come to our attention regularly within physician discussions of Hospital employment.  Hospital systems have been fairly reactive and are tailoring their contracts to remedy such objections, but a certain stigma permeates throughout the physician public which has kept most conversations mute or placed to sidelines…for now.

Hospital Real Estate Strategy: 2012 and Beyond

The following approaches, which are being implemented by hospitals and indicative of the strategies that our firm is undertaking, are beginning to take effect across the nation.

Monetization.

For an example, Baylor Health Care System chose to extract capital from its existing medical real estate portfolio through a real estate monetization process. In addition to generating funds that could be used to support new strategic initiatives, the system’s leaders believed that the proceeds generated from the disposition of to-be-constructed and existing facilities would enable the organization to obtain more favorable debt yields, as the liquidity from the monetization was perceived as a positive offset to the new liabilities it will pose. In this case, the health system started the initiative by identifying and qualifying real estate advisors. The organization selected an advisory group that had the capabilities of analyzing both owned and leased real estate, had access to an extensive database of investors and developers, and was experienced in working with physician real estate owners. After running a competitive bidding process, the health system selected one group to acquire its real estate portfolio. The transaction generated a tremendous amount of liquidity for the health system and created a future real estate partnership. The formal transaction process also served to inform major healthcare real estate investors/developers of the health system’s growth strategy. Doing so has created a potential set of financing options for the organization’s future real estate development capital needs. Any monetization process does not come without its challenges, however, given the fact that several potential parties may become involved (health systems, developers, investors and physician group owners, international, etc) seeking to purchase the facilities, all with separate, unique objectives. Also, the time required for the ideal purchaser to perform due diligence is usually much longer than what is anticipated. However, if the purchaser is knowledgeable about keeping open transparency, it alleviates the concern that may be among the staff and physician groups who have knowledge of the potential transaction.

Renovation.

Another approach that which will save cost and time, one that we will see for years to come, is to renovate existing facilities rather than building new. Clear Lake Hospital recently decided to redevelop/expand the woman’s and children’s units as well as the Heart and Vascular unit. They are incorporating a new 150,000 square-foot facility Patient Tower with state-of-the-art operating rooms, pre-operating and recovery rooms plus a 30-bed adult ICU. As hospitals will continue their growth via acquisition or partnership with physicians, new facilities are necessary in a competitive healthcare arena. As hospitals slow their growth, they will monetize and either pay down debt, growth through outpatient facilities, search for other partnered projects or renovate other existing facilities.

Cost Control.

Materials costs are another area that hospitals will be more aware for expense control. As an example of this approach, a hospital that our firm has negotiated, sought bids for the development of a new satellite medical office building. The process yielded many proposals, but one developer’s proposal to use tilt-wall construction for the building, rather than a more costly method, was deemed more favorable than the others. The developer’s construction budget was approximately a moderate percentage lower than that of other bidders. After careful consideration, the hospital ultimately chose the developer for the project—with favorable results. By keeping the construction costs low, the facility has been able to attract tenants with market-competitive rental rates as well as construct a well built facility that will endure the elements.

Joint ventures.

Real estate owners have enjoyed attractive financing by using sizable portfolios of real estate as collateral for bank loans or lines of credit. Hospitals that partner with a real estate investment trust (REIT) or a private real estate company can also benefit from the partner’s core “real estate competency.” For example, real estate companies are able to bring services such as property management, development, and space planning services to the hospital’s assets. Some also are able to share savings related to the packaging of the medical facilities that they may acquire or develop, creating cost savings opportunities through economies of scale. As is typical of such arrangements, once the medical facility was completed, the real estate owner became the landlord and leases the facility back to the hospital, thereby allowing the hospital to simply play the role of tenant and focus on its core competency: providing healthcare services. This underscores the symbiotic relationship between real estate owners and their healthcare clients which will be more prevalent in the future as hospitals exit the real estate business. The owner-partner will rely on the medical tenants’ present and future credit quality for their own cost of capital, so they have an incentive to align their interests with those of their tenants. This relationship between the hospital and the real estate capital source allows the hospital to focus its funds on its core mission.

Robert S. “Bob” Lowery is Managing Partner with MREA | Medical Real Estate Advisors, a full-service Houston-based healthcare real estate firm.

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Is It Time To Purchase Your Medical Office Space?

We believe that the unique timing of this commercial real estate down market cycle coupled with historically low interest rates has created an investment opportunity for physicians. There are several advantages of investing in medical office space for your organization and only a few disadvantages.  And, considering inflation is upon us, rents appear to go in only one direction – up, up, up!

As for the negative factors of investing in medical or commercial real estate, as always it remains the large cash outlays and potential tenant vacancy. When you are purchasing for your organization, these disadvantages are essentially erased.

When purchasing a building for use, initial down payments begin as low as 10-15% of the purchase price. The most coveted loan made by commercial lenders is via medical and corporate users, purchasing space for their own use.  Similar to residential lenders, the most attractive interest rates and down payments are given to owner occupants for their primary residence, and similarly, commercial lenders favor user loans over non-user or investment loans.

When we are assisting physicians with the purchase of office space, one of the major advantages that sells the deal is that of principal reduction.  When you own space, each month a portion of your occupancy cost has reduced the principal balance of your mortgage. Often times, when our group is commissioned to dispose a property, the seller will admit to purchasing the building to control costs or to keep the organization in one place.  But, often times, the profit from a disposition turns into a windfall that was not expected.  Because physicians are paying their mortgage in as few as 5, 10 or 15 years, the building purchase has the potential of providing a supplemental retirement package upon resale.

Returning to the inflation topic: Historically, purchasing medical office space has increased rents over a period of time.  When purchasing space, you control the increases and not the other way around. This is a simple point, but one that needs to be made.

Another inflation benefit is the positive leverage of financing your space. For example, if you get a 7% return on $100,000 that is $7,000. If you choose to place $100,000 down to purchase a $1,000,000 medical office building, at only 2.5% inflation, that equates to $25,000 per year annually.

Keep in mind, it is the power of positive leverage and inflation that creates wealth. Contact Robert S. “Bob” Lowery for your commercial and medical real estate needs.

It is time.

Houston’s 2010 Business Survey (:The More The Merrier:)

Robert S. “Bob” Lowery:

The results will be posted in the upcoming 2010 forecast.  Yes, my elves will work through the holidays.  Best wishes to you and yours this holiday season!!