Leasing market for medical offices hits downturn

If you rent, experts advise negotiating lower rates or seeking various perks. If you own and lease space to others, customer service is increasingly important.

By — Posted Dec. 14, 2009

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Would you like a golf club membership with your medical office lease? How about a few months of free rent? Fresh paint for the walls? How about just lower rent?

"Everybody is renegotiating their leases," said Tom Dalcolma, a partner in Street Sotheby's Medical Realty Advisors in Columbus, Ohio. "It's clearly a tenants' market."

The real estate slump, combined with tighter credit, means that fewer medical office buildings are being built. But after a previous construction boom, there is still more supply than demand.

So rents are creeping downward, and vacancy rates are going up. These are the conclusions of the Medical Office Research Report published by the real estate investment company Marcus & Millichap. The report looked at the second half of 2009.

For physicians who rent space, this means it's a good time to look for a better deal. But those who lease to others might need to take extra steps to keep tenants happy.

The report said the market for medical office buildings is "much more stable than traditional office properties." But vacancy rates have gone up and are expected to continue to increase, despite the fact that fewer medical office buildings are being built and some projects have been canceled. Approximately 10.1 million square feet of medical office space are scheduled for completion this year, a decline of 30% from 2008. Only 7 million square feet are expected to be built in 2010.

"We have seen a little bit of a dip in occupancy, but not a lot," said Gordon Soderlund, senior vice president for strategic relationships with DASCO Companies, a medical building developer and manager in Palm Beach Gardens, Fla. "Physicians generally don't move that often, and a lot of hospitals have suspended capital projects."

Rents down nationwide

Rents also went down in most areas of the country, because fewer practices are expanding into new space. Some practices are becoming smaller while others are closing.

These market changes have resulted in a decline in the average asking price for medical office building rent. Nationally, the per square foot costs declined from $24.90 in the third quarter of 2008 to $23.90 in the third quarter of this year, according to Marcus & Millichap. Only rents in Texas inched up, from $22.67 to $22.86. Near term predictions are for average rents nationally to go down further, to $23.42. The difference between asking rents and the amount physicians actually pay is unknown.

Many experts say it's a good time for renters to ask the landlord to renegotiate your lease, even if there is still time left on it. Landlords may be amenable to locking in a lower rate if the lease is extended, although they can be understandably hesitant. Long-term leases can be attractive to future investors, but reduced rents cut the value of the building, making it more difficult to sell or refinance. Those who negotiate medical office leases say if the landlord won't lower the rent, physicians may be able to get lower property-related expenses or other perks.

"There are other benefits [owners] can bring to the table," said Ken Scheper, finance director of Alliance Primary Care in Cincinnati. He is renegotiating several leases for his medical group.

Landlords might be willing to throw in a few months of free rent, provide money to update the space, cover common-area maintenance charges, or pay for something like a golf or health club membership.

"If you lower the rents, you are actually devaluing the building," Soderlund said. "A two-year membership at a golf course -- that may not even get documented or show in the lease itself. It's not being deceptive, because a landlord is still collecting these rents, but they happen to offer some incentives or concessions to keep a tenant."

Time to look elsewhere -- or expand?

If the lease cannot be changed, experts say, it might be worthwhile to shop for other spaces that may be inexpensive enough to justify buying out the remainder of the existing lease. It also may be a good time to think about expanding the practice space, experts said, because new developments might require lower commitments of time and money.

For example, on Oct. 15, Oaks Development Group announced the launch of a physician incubator space in a 20,000-square-foot medical building under construction in Palm Coast, Fla. Incubator spaces, common in industry and high-tech fields, are intended to provide an economically supportive environment for new business start-ups.

The Oaks project includes eight offices, totaling 2,200 square feet, that have been designed as shared space equipped with the basics, such as exam tables and high-speed Internet. Only a one-year commitment is needed, rather than the standard five- or 10-year lease many practices sign. Plus practices can rent an office for as little as two half-days a week.

Various office-sharing arrangements are common among practices or with hospitals, but many experts say such an arrangement with a developer is unusual.

"We saw a lot of physicians reluctant to commit to a long-term lease. This allows them to put their toe in the water and see what revenues are going to be like," said Charlie Barker, Oaks' director of development.

While this is one example of how national medical office trends may work to the advantage of physicians who rent, physicians who own medical office space are on the other end of the equation.

For owners, now more than ever, customer service is key. "First and foremost, [owners should] make sure that they are very, very in tune to the needs of the tenants," Soderlund said. "If your service is the top quality, they will be more likely to renew, and it will be harder for them to leave."

Experts recommend that owners make sure exteriors, entranceways and lobbies are maintained. Carpeting may need to be replaced regularly because of heavy foot traffic. Periodic tenant surveys also may help identify needs.

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Rents down everywhere but Texas

The cost to lease medical office building space has gone down in most areas of the country. The drop in rents per square foot is not as great as for other commercial real estate and varies by region.

Third quarter 2008 Third quarter 2009
U.S. average $24.90 $23.90
Midwest $20.80 $19.90
Texas $22.67 $22.86
Southeast $23.87 $23.20
Southwest/Mountain $24.33 $23.68
Northeast $25.14 $24.90
California/Pacific Northwest $30.63 $29.45

Source: "2009 Real EstateInvestment Outlook," Marcus & Millichap's Medical Office Research Report, Oct. 12 (link)

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