Vacancy rates rising for medical office buildings

More space gives physicians room for negotiating leases and office construction costs.

By Karen Caffarini — Posted March 2, 2009

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Real estate and health care analysts say even though the medical offices sector is still considered healthy in the mostly comatose commercial real estate market, it is beginning to show signs of fatigue.

While that might mean trouble for physicians who own or want to own medical office buildings, those who lease might be able to turn sagging fortunes to their advantage.

Experts say the jump in unemployment and subsequent drop in medical dollars spent have caused cash-strapped doctors and hospitals to pull back on expansion plans. The retreat comes after years of robust construction, leaving a growing number of vacancies in new buildings.

More than 17.5 million square feet of medical office space was completed in 2008 and 16 million in 2007, with 13 million projected for 2009, said Alan Pontius, senior vice president and managing director for Marcus & Millichap's Healthcare National Office and Industrial Properties Group in San Francisco.

These buildings were planned when interest rates were low and the health care industry was looking ahead to accommodate aging baby boomers and meet technology needs. But now financing is difficult to get, and for many practices, the number of patients coming in no longer warrants a larger office.

"A majority of these new buildings will not be substantially preleased when they open. Clearly, the vacancy rate will go up," Pontius said. He said medical-office vacancies in 2008 were up by nearly one percentage point, to 11%, but he added that is still a healthy number compared with the 17% in general office vacancies.

Once-booming Sun Belt locations are expected to see vacancies rise significantly. The Southwest/Mountain region saw vacancies jump to 13.4% in 2008, according to Marcus & Millichap's Medical Office Research Report for 2008. Florida's vacancy rate rose to 11.6%, and that number is expected to increase this year.

"Medical office condos have had a rough time in the Phoenix area in the last 24 months. A lot filed bankruptcy. Rents are no longer escalating like they had been," said Garry Davis, of Scottsdale, Ariz.-based Davis Appraisal Services, which tracks health care construction trends in the Phoenix area.

Davis said such a situation gives doctors more flexibility with their landlords. He said some doctors have had success asking for reduced rent or for the landlord to bear the cost of building out space.

Ken Scheper, president of KS Consulting in Cincinnati, a medical management consulting firm, said if the landlord resists, ask, "If we move out, who will you rent to?"

Scheper said the landlord for one of his clients agreed to purchase a new piece of ultrasound equipment for the five-physician group, provided the group extend its lease from four years to five. The group was able to keep its current rate and lock it in for all five years, Scheper added.

Moving on

The struggling market could make it easier and less expensive for doctors to move.

"My firm actually is having commercial agents calling to let us know that they are willing to work with physicians who are looking for additional or new space, even in the more desirable locations close to hospital and medical areas," said Tannus Quatre, principal of Vantage Clinical Solutions Inc., a Bend, Ore.-based consulting and management firm that works with medical practices.

Scheper said it is usually difficult to get out of a lease, but physicians could see whether their current landlord has an office at another location that would better suit their needs. "They likely will be willing to work with you, to keep one space filled instead of two empty."

Quatre said before deciding on moving to either a larger or smaller space, physicians need to determine whether the amount of medical revenue they collect per square foot is on par with the industry. He said the benchmark in medical collections per square foot is $341.61 for multispecialty groups and $284.26 for family practice clinics.

He said physicians also need to determine whether any expanded space will lead to justifiable increases in volume per capacity, measurable improvements in operational efficiency, or improved revenue/profitability per square foot.

Davis warns physicians not to get involved with any bankrupt properties, as there could be legal hassles or reasons why the property went bankrupt in the first place, such as poor location.

Some physicians might be tempted to move ahead with plans to build their own medical offices, given that materials and labor costs are beginning to drop. But analysts recommend waiting, given the uncertainty in the construction, banking and health care professions.

"Now is the time to be cautious when looking to build a doctor-led medical building off a hospital campus. There is less need for these overall," said John Winer, executive vice president of Seavest Inc., a health care real estate firm in Celebration, Fla.

Davis also pointed out that bank financing is still difficult and expensive to obtain, even for usually stable health care facilities.

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Medical office building trends

While still healthier than other commercial construction sectors, medical office building is showing signs of fatigue.

Trend 2008 2009 prediction
Construction completed 17.5 million square feet 13 million square feet
Vacancy rate 11.1% national average From 9.2% in West/Pacific to 13.4% in Southwest/Mountain
Rent $23.94/square foot $24.06/square foot

Source: "Medical Office Assets Resistant to Ailing Economy," Marcus & Millichap (link)

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