Construction booming in medical office building market

A significant increase in medical office building construction means landlords might be willing to make the extra effort to sweeten the deal to ensure that physician practices will fill the space. And it might not be a bad time for a practice to sell an existing property, either.

“Buildings are going up left and right, and there are lots of opportunities in the marketplace,” said Paul D. Heiserman, senior vice president of health care real estate with Equity, a services firm based in Columbus, Ohio.

No organization issues an official report on medical office building activity, but major real estate companies say they believe new buildings are going up faster than ever. Sales of existing buildings are highly active as well.

According to a Jan. 11 report from Colliers International, a global real estate company, 33.7 million square feet of medical office building space was under construction across the country in the third quarter of 2012. A survey of 156 health care real estate developers released in December 2012 by Newmark Grubb Knight Frank, a brokerage based in New York, found that 65% said development would be higher in 2013 than in 2012.

Medical office building industry experts say the numbers indicate that future construction will be much greater for the foreseeable future than the 7 million square feet built in 2010, as reported April 21, 2011, by the Urban Land Institute, a nonprofit research organization.

A previous pre-recession high was the 13.7 million square feet added in 2005, according to data from Marcus & Millichap, a national real estate brokerage firm based in Calabasas, Calif.

Why now?

The recent burst in construction is believed to be a result of several factors. One is demand that built up during the 2007-09 recession, when some projects stalled or never got started, said K.C. Conway, Colliers executive managing director of real estate analytics, who wrote his company's report.

Also playing a role was the 2012 U.S. Supreme Court ruling upholding the Affordable Care Act and the certainty that millions more people will be added to insurance rolls in the next few years. Investors, including many real estate investment trusts, developed a keen interest in medical office buildings. Duke Realty, a real estate developer and manager based in Indianapolis, reported in January that it expects more building as high-acuity and emergency services increasingly move off of hospital campuses.

“Hospitals are staking their claim in their geographic areas by creating new buildings and putting their brand name on the sign,” said Philip J. Camp, a principal with Hammond Hanlon Camp, a health care investment banking firm based in New York.

In a turbulent real estate market, medical office buildings, a historically stable investment, became extremely attractive to investors looking for safe places to stash their cash. The delinquency rate for commercial mortgage-backed securities was 9.2% for the general office market in 2012, according to Marcus & Millichap, but only 3.3% for medical offices. Landlords of empty retail properties, especially those ravaged by the closings of big-box chains such as Circuit City and Borders, are making deals to have those spaces retrofitted into medical office space, Duke Realty reported.

Demand's effect on prices

How the building boom affects rents will vary by market, but real estate developers note that in most areas, demand is such that rates are stable or still going up. However, medical office real estate experts say physicians looking to lease or buy should have some leverage to get reasonable prices, decent credit arrangements and additional money to remodel the space. This is particularly true because, although financing for new developments has loosened up, it still has challenges. Most lenders will not finance a building that does not have significant tenant commitment. Also, doctors tend to move less often than commercial tenants, which increases their appeal.

“I get lenders and developers calling me all the time saying that they have a great program for physicians,” said Rebecca Harrell, medical office specialist with Henry S. Miller Brokerage in Dallas. “Doctors are some of the most favored clients out there.”

Realtors say medical office space tends not to last long on the market. A statement issued Jan. 11 by Jones Lang LaSalle, based in Chicago, called medical offices “the investment darling.”

Marcus & Millichap estimated that medical office vacancy had dipped to 11% in 2012, the lowest rate since 2008. The Urban Land Institute report indicates that 64 million square feet of additional medical office space would be required during the next decade. Medical office buildings “will not be plagued in future years by continuing excess capacity, as is the case with residential real estate, malls and office buildings,” the report stated.

But what does this mean for physicians who already own medical office buildings and are looking to sell? Will buyers put their money into newer, shinier structures?

Duke Realty reports that it expects purchases of existing buildings to be active. The same factors that drive medical office construction are increasing interest in existing buildings.

But industry insiders have some advice for physicians who plan to retire or close a practice: Try to sell the building a few years before that happens. Medical office real estate experts say a building that can be bought and then leased back to the practice is an attractive investment for a buyer. The building will be harder to sell without a tenant.