The race for space: A medical office building boom

The U.S. is in the middle of a historically high rate of medical office construction. Why is it happening, and how long can it last?

By Bob Cook — Posted Feb. 26, 2007

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When MidAmerica Cardiovascular Consultants of Oak Lawn, Ill., moves into its half of a newly built 30,000-square-foot facility this fall, it will be among the large number of practices helping to make medical office construction one of the country's hottest growth industries.

About 13 million square feet of medical office space is expected to be built in 2007, down only slightly from the record 13.7 million square feet added in 2005 and 13.2 million in 2006, according to Marcus & Millichap, a national real estate brokerage firm. That's well above the average 8.5 million square feet that was added each year between 2000 and 2004, a number that was already historically high.

The boom in the medical office construction industry isn't expected to end anytime soon. Rents are going up, vacancy rates are dropping or remaining stable, and existing, highly desirable medical buildings are still fetching premium prices, a sign that the demand for medical offices is a long way from being sated.

Analysts say there are plenty of reasons that medical office construction is so hot: the rush to build in fast-growing suburbs; medical and information technology needs that can't be handled in existing buildings; pent-up demand from practices for extra space; and the migration of more procedures from the hospital to an outpatient setting. A concurrent hospital construction boom -- a record $23.7 billion in 2005, according to the U.S. Census Bureau -- also ends up creating new office space.

But the biggest driver, analysts say, is the same one pushing the hospital boom -- the movement of the baby boom generation into old age.

The U.S. will have 77 million people older than 55 in 2010 -- up 29% from the start of the decade, the Census Bureau predicts. By 2020, that total is expected to reach 98 million.

"That is only going to lead to one very clear need, and that is increasing demand for medical services and things to enhance the aging of the population," said Alan Pontius, national director for Marcus & Millichap's Healthcare Real Estate Group, based in San Francisco.

Baby boomers are changing what it means to grow older. What that means for medical offices is a demand for greater convenience in medical services. Boomers wants medical buildings that have the warm look of a nice hotel, not the cold look of a clinic. And while they're expected to make more trips to the doctor for aging-related conditions, they'll also be looking for ways to keep themselves well.

Even with threats to cut Medicare reimbursement to physicians, medical office builders are betting boomers will still generate enough revenue -- through sheer numbers as well as a willingness and ability to pay cash for extra services -- to justify the construction.

MidAmerica Cardiovascular is well aware of these trends, serving a patient base in an inner-ring Chicago suburb that, on average, has older residents than most suburbs.

Growth of the 20-cardiologist practice was straining the space in its offices adjacent to Advocate Christ Medical Center, so even considering adding new services was out of the question, said Masood Qazi, MD, co-president of the group.

Meanwhile, the parking situation was getting to be too much for older patients. Parking in a garage, the closest option on the medical center campus, required a walk to the elevator, down a long corridor, through the hospital lobby, along another long corridor and then to another elevator for MidAmerica's fourth-floor office. "It's like a stress test," Dr. Qazi said.

MidAmerica's new building is two miles away from the hospital, but Dr. Qazi figures the easier access, as well as the potential increase in amenities and improvements, is well worth giving up closer proximity to the hospital.

Growth is everywhere

New construction wasn't necessarily MidAmerica's first choice. Dr. Qazi said the practice had looked at existing buildings. When a local developer contacted them about building, MidAmerica became a co-investor, with other physicians being sought to fill out the structure.

Medical office building in the past had been a minor business, in the hands of hospitals, a few specialized developers and physicians themselves. Now major companies, such as Indianapolis-based Duke Realty, have been buying or forming joint ventures with medical office developers, while other builders are starting their own medical office units.

Builders are enticed not just by the baby boomer demographics but also by the relative stability of medical office buildings, analysts say. Once physicians move into an office, they tend to stay longer, though no statistics exist to state exactly how much longer. It also helps that physician practices are much less likely than a general business tenant to suddenly go out of business.

Almost every part of the country is reporting active medical office construction. But the fastest growth, analysts say, is coming in the outer, expanding suburbs, particularly in Sun Belt and far West cities.

Phoenix, for example, had $1 billion worth of medical construction, including offices and hospitals, in both 2005 and 2006, said Garry Davis of Scottsdale, Ariz.-based Davis Appraisal Services, who tracks health care construction trends in the Phoenix area. The metropolitan area has 16 acute-care hospitals under construction or in the planning stages, and Davis said each facility will end up spawning about 250,000 square feet of new medical office space.

Most of the projects are in Phoenix's new-growth, master-planned suburbs, in which each housing/retail development includes at least one health care facility as a selling point, particularly for the high number of retirees flocking to the area. According to the U.S. Census Bureau, Phoenix's 55-and-older population is expected to grow 25% between 2005 and 2010. The fastest-growing 55-and-older population, at about 30%, is in Austin, Texas.

Suburban growth is pushing construction even in states with certificate-of-need laws. In Minneapolis-St. Paul, a building boom is under way in part thanks to a new hospital in suburban Maple Grove, the first Minnesota hospital approved since 1980. Local analysts note practices are also sprouting up alongside freeway exits, retail strips and other highly trafficked areas. And existing office buildings have been, and are being, renovated to serve medical needs.

Steve Brown, vice president of the health care real estate group for Bloomington, Minn.-based United Properties, says he has seen new development take a retail-like angle not only in location, but also in services. "One of the common themes you'll see if you were to dive into some of the different types of development is [physicians, hospitals and developers] trying to find a niche that someone can put out that can increase the patient draw," Brown said.

But for how long?

Vacancy and rental rates support that there is a demand for more space. In most areas, vacancy rates are comfortably less than 10%, while rents are going up about 4% per year, according to Marcus & Millichap.

The questions now are less about the underlying market forces and more about practical matters of health finance and personnel. The construction boom has only heightened the debate over whether brand-new facilities will result in more efficient care that keeps a lid on health costs, or whether the need to recover the costs of the new buildings will result in accelerating costs.

Then there is the issue of who will fill the buildings. While plenty of baby boomers will be seeking care, getting it might be another thing. According to various estimates, by 2020 there will be a shortfall of 65,000 to 200,000 physicians. Adding the difficulties that some physicians already have with finding enough nurses, medical assistants and other personnel could mean some of these new buildings will eventually sit empty.

Right now, developers aren't worried, although Brown, the son of an oncologist, says "some would argue this is everybody's problem, because [filling the buildings] becomes part of the health care conundrum." The need to replace obsolete facilities is part of health systems' attempts to position themselves as modern and ready to handle today's patients, he said. "The desire and need to compete for the patient business is driving these decisions."

Dr. Qazi isn't seeing things in such large-scale terms. For his practice, he's happy a new building will allow MidAmerica Cardiovascular to perhaps expand into studying and treating sleep apnea, or broaden its imaging services, or add pulmonologists -- and to have its own conference rooms and an employee lunchroom.

"There's a lot of excitement to have our new building, new facilities, new furniture," Dr. Qazi said. "An old building is like an old shoe. To dislocate yourself and go to a new place, you always have fond memories, you have nostalgia. But there's no question this [current location] is too cramped."

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Construction forecast

Real estate broker Marcus & Millichap believes medical office construction will stay above 13 million square feet for the third straight year. Here's why:

Job growth 0.9% increase: When more people are working, in theory, more have health insurance.

55-and-older population 2.7% increase: The baby boomers' entry into the 55-plus category is creating a population bulge, and more people who see the doctor more often.

Class A medical office vacancy 0.1% decrease: Even with all the new space available, the most desirable medical office properties are still full. The 2006 end-of-year vacancy rate nationally was 9.3%, which is well below the general-office rate. Developers like medical offices because lease terms run about 60% longer than for general office buildings and the lease renewal rate is about 90%.

Asking rents 4.3% increase: The average rent at the end of 2006 was $23.55 per square foot. The growth in rents tells developers there is still a large demand for office space.

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First rule of development: Have everyone on board

Some physicians are helping the medical office construction boom, analysts say, by eagerly investing as partners with developers, getting a brand-new facility and collecting rent.

But experts say physicians should not jump into this boom unless everyone in the group is ready to take on the responsibility of financing construction and being a landlord.

"When you get a 20-person practice and you start owning a piece of real estate, what becomes most important is you have to have the right ownership structures," says Steve Brown, vice president of health care real estate for Bloomington, Minn.-based United Properties. "The groups that have done it successfully have had a model in between -- not overly fair to anybody, not overly fair to everybody."

Individuals in the group aren't always on the same page. A physician in his or her 40s might be ready to put aside a chunk of money for perceived long-term gain in real estate, but a physician in his 60s probably wouldn't be, Brown said.

"Unless you have everybody into the deal, it makes it very, very, very difficult to have everybody feel happy at the end of the day."

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Office design can help healing

You know about evidence-based medicine. But what about evidence-based design?

Since 2000, a study called the Pebble Project has looked into how design of medical office buildings and hospitals can assist in improving outcomes and patient experiences. The project is a consortium involving the Concord, Calif.-based Center for Health Design and 37 hospital, health system and corporate partners. Partners pay $30,000 a year to be part of the project, $35,000 per year if they are manufacturers. The Robert Wood Johnson Foundation has supported some Center for Health Design and Pebble efforts.

Most of the first research to be released has been hospital-based. But the project reports decreases in staff turnover and increases in patient satisfaction with new buildings that incorporate more natural light, private rooms and other touches intended to make the facilities less "clinical."

Hospitals also reported a sharply reduced number of patient falls -- as many as 75% fewer at Methodist Hospital's new cardiac care center in Indianapolis -- because facilities were built with better angles, improved lighting and improved room layouts that allowed for more observation.

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