Continuing on our path towards emerging from what some have considered the worst downturn since the Great Depression, the majority of the Greater Houston medical landscape has weathered the storm in good shape. Now, with the advent of healthcare insurance reform, many supply-demand economists are predicting a solid future for the healthcare real estate industry and its continued growth.
Availability of Capital
Although medical real estate did not experience the same severe disruption to capital lines that commercial real estate faced in late ’08 and through ’09, capital remained available to the sector; albeit at a higher cost. Debt financing demanded greater equity, higher pricing, guarantees and committed take-out financing, which made it it difficult to finance real estate projects. Many institutional investors were on the sidelines. However, the projects with average to good fundamentals were funded.
From this experience, the industry was forced to adapt to a lower tolerance to risky ventures. Thus, due to this collapse in rick beginning in ’08, we can guarantee investors will no longer come to expect 90 percent debt financing, sub-6.25 percent cap rates and lax underwriting by lenders. Significantly higher equity requirements, a strict focus on Class A and newly built properties, rigid due diligence procedures, and higher pricing have become the standard.
Pre-2008, many of the larger banks consumed financial instruments that we now know were toxic waste, subprime mortgages being the most publicized. In 2007, and well into 2008, banks were issuing funding commitments on development projects with 0-25% pre-leasing. When the credit markets turned south, most of those projects were canceled, foreclosed upon, or the related hospitals booted the developer and either shelved the project or turned it over to another managing entity. Those institutions that maintained sensible lending criteria and stuck to their knitting remained in the market and found a loyal group of developers/borrowers. Lender due diligence has become more rigid. Pre-leasing requirements of 65-75 % on new development projects are now required.
Unfortunately, many real estate practioners are attempting to enter this sacred market without ever stepping a toe in. These recent entrants into the market will find themselves redlined and eliminated from further consideration, due to a lack of reliable capital, a depth of experience, or both. On top of this, the relationships that have been developed by hospital to physician, physician to physician, and physician to developer requires a long history of accomplishments prior to jumping in head first.
Hot Investment Sector
Throughout the recession and the credit crisis, an imbalance between the supply of buildings and the capital seeking to acquire them has caused values to remain buoyant. Prior to the recession, capitalization rates were firmly trending downward, driven by higher prices and sustaining a seller’s market. Cap rates were in the mid- to low-6s with a few trades breaking the 6 percent barrier. Once the recession hit, the volume of transactions subsided as credit was difficult to obtain, driving down values and sending cap rates north of 8.5%. Meanwhile, most medical buildings continued to exhibit strong fundamentals during this period, unlike commercial office, industrial and retail properties which have suffered increasing vacancies, delinquent tenants, past due loan payments and lenders calling loans.
This imbalance is more pronounced today as institutional investors such as REITs are flush with cash seeking quality investments. Hospitals are the main source of supply as they consider monetization strategies to sell non-core real estate assets. Because a financial strategy of diversifying capital sources is gaining strength among the hospital community, the volume of monetization transactions and outsourcing new development projects to ‘established’ healthcare real estate players should increase. There is ample capital awaiting these opportunities.
Search for Stability
Many hospitals and health systems suspended projects during the recession. Why? Inaccessibility of capital, weaker operating performance due to declining patient revenue and increasing bad debt and charity care, uncertainty surrounded the economy and employment, and the political gamesmanship regarding healthcare reform. Even when capital was available, hospital CEOs and their staffs made strategic decisions to delay expansion efforts because of these market uncertainties.
Overarching all of this, however, is the future pace of an economic recovery. As of today, economists are debating the threat of deflation, a double-dip recession, and the potential onset of inflation. We are in tenuous economic times, both domestically and internationally. Consumer confidence is lower than estimates. Housing prices continue to search for a bottom. Commercial real estate loans are defaulting at an alarming pace. Corporations hoard cash awaiting the next economic shoe to drop, thereby delaying capital spending… hiring. Until the economy finds its footing, our country will face high unemployment rates, depressed capital spending levels and consumer cautiousness. Healthcare providers will continue to struggle over decisions to proceed with new facilities.
Construction Costs..Up or Down?
One of the recession’s benefits has been the resulting decrease in construction labor and materials. Depending on the region of the country, developers have experienced a 10-20 percent reduction in construction costs over the past 18-24 months. This phenomenon, though, may be short lived as the market has experienced increases in most construction items. However, with little competition from the commercial real estate market for new construction resources, stable construction prices may prevail a bit longer.
A Final Word
All said, where the healthcare real estate industry goes from here may appear promising or frightening, depends entirely on your working experience within the sector. While I would implore real estate professionals to always seek more education and relationships within this sector, be prepared to serve an already serviced industry.