The challenges faced by medical office building investors in 2023 which have led to a decline in overall activity... 
The challenges faced by medical office building investors in 2023 which have led to a decline in overall activity…

Higher borrowing costs, reduced access to capital and increased building expenses are impacting the medical office building (MOB) market as healthcare providers must consider alternatives regarding buying, building or leasing their facilities. These market conditions come amid a backdrop in which medical office building deal activity in 2023 has fallen behind the pace set in 2022.

“Construction costs and lead times have skyrocketed, primarily a result of supply chain and logistical issues during and post-COVID, along with labor shortages and inflationary pressure,” said Collin Hart, managing director of ERE Healthcare Real Estate Advisors. “Overall, construction costs have increased more than 30% since pre-COVID times. New facilities are, or should be, more efficient, perhaps requiring less space. This is a result of adapting to hybrid or remote staff members, which is particularly applicable to non-clinical employees like scheduling and billing staff.”

Hart added telemedicine has also changed the delivery of care, necessitating fewer exam rooms in certain situations.

“All of this serves to create more efficiency, reducing the space, and helping offset the cost of occupancy,” Hart said.  

Hart advised that a buy versus lease analysis can be a valuable tool in making the best decision.

“Looking purely at the capital and ongoing cost of occupancy, a healthcare operator can model out the initial cash outlay and ongoing costs in each scenario,” Hart said. “Leasing will be less capital intensive, but it has less upside.

Medical office building deal considerations

Other considerations that come into play include the risk tolerance of the operator, the required return, the demand for upside and the desire for long-term control.  

“Many of these considerations are more emotional and less quantifiable,” Hart said. “It’s easy to model out the costs, but it’s important to remember that these decisions are being made by people, not computers. Spreadsheets don’t sell, but stories do. It depends on what story a health care operator is telling themselves and/or their partners as to whether it is better to buy, build or lease.”

The interest-rate component has become increasingly problematic as the Federal Reserve has continued a policy of trying to reduce inflation by boosting borrowing costs.

“Higher interest rates have lowered asset values, which has slowed transaction activity between investors,” said Jay Johnson, U.S. Practice Leader, Healthcare at JLL. “Medical office owners with significant variable-rate debt, debt with near-term maturities or expiring near-term interest rate hedges, are more likely to sell. There are several of these situations being actively marketed today, and the expectation is that there will be more to come in 2024 as 5-year term loans issued in 2019 approach maturity.”

Reports have stated most Fed officials expect one additional rate hike this year, according to minutes from their September meeting. Some officials stated how fast inflation slows in the coming months will determine how long rates stay elevated.

“Rising interest rates negatively impact the value of assets financed with variable-rate debt or with near-term loan maturities that are coming due and will soon require refinancing or new interest-rate hedges,” said Andrew Milne, Senior Managing Director, Capital Markets Medical Properties Group Co-Leader at JLL.

Milne added that increasingly expensive financing is also slowing the construction of new medical office facilities. “Speculative projects, while few and far between in health care, have been more negatively impacted than projects with confirmed tenancy, with construction lenders very focused on minimum pre-leasing thresholds, and in most cases offering lower proceeds,” Milne said. “Investors prefer having certainty, and this year has been notably uncertain as it relates to Fed interest-rate decisions and the future outlook.

“Market sentiment has moved recently to an acceptance of higher-for-longer rates and investment decisions are being impacted accordingly. Lenders are also being impacted by changing reserve requirements, stress tests and other non-Fed, rate-related measures that are collectively creating a more restrictive lending environment.”

The U.S. central bank held its key lending rate unchanged at a 22-year high in September. There is uncertainty regarding how much the Fed’s 11 rate hikes since March 2022 will weigh on economic activity. 

“Costs are stabilizing at their current elevated levels and not likely to decline,” said Andrew Volz, Research Manager at JLL. “There’s too much in the pipeline, too many lingering delays, ongoing labor shortages and potential disruptions to key materials with geopolitical issues that are setting floors on cost growth. There’s no reasonable expectation for a return to the pre-pandemic pricing regime.”

Volz said market participants are revisiting their strategies at the most fundamental levels, asking how much space they really need, and how we lean into the needs of the post-pandemic environment. 

“Firms want hard data on how well things work and they are concerned with committing resources to big changes, despite knowing that it’s necessary,” Volz said. “Lenders are tightening standards and seeing interest in [commercial real estate] loans fall, and things are going to keep trending that way.”

The consumer price index in September 2023 increased 3.7% from September 2022, and despite recent reductions in the rate of inflation, some economists have said it will take some time for inflation to return to previously lower levels. The Fed aims for a 2% annual inflation rate over the long term. Fed officials don’t expect that to occur until 2026.

“When considering build vs. lease, having been negatively impacted by rising interest rates, labor shortages, inflation and intensifying competition, health systems are demonstrating an increased focus on balance sheet management and a more thorough review of capital allocation – often determining that they use our capital or structured finance solutions rather than their capital,” said Benjamin W. Ochs, the CEO of Anchor Health Properties. “Approximately 50% of our development projects are in a fee-for-service capacity, often containing a structured finance component, and the other 50% is a more traditional capital solution where we provide capital either in full or as part of a joint venture arrangement with healthcare providers.”

According to the LevinPro HC database, there have been 166 medical office building deal announcements in 2023 through Oct. 13. This represents a 3.5% drop compared to the 172 medical office building transactions posted during the same period in 2022. This year’s 166 deals are running 22.1% below 2022’s full-year total of 213. The amounts were 160 and 74 in 2021 and 2020, respectively.

“Across the healthcare real estate industry, the average cost of construction has increased significantly post-COVID, including labor, cost of raw materials, supply chain shortages, etc.,” Ochs said. 

Ochs added his firm has observed certain markets, including Charlotte, Denver, Phoenix and Raleigh, outpacing the increased cost of construction across the rest of the U.S.

The deal volume downturn has been accompanied by a sharp fall in sale amounts that have been revealed. The LevinPro database reveals the No. 1 deal of 2023, Big Sky Medical Real Estate’s $190 million purchase in January, was significantly below the fifth-largest deal of 2022. That was the sale of a medical office building portfolio to Nuveen Global Cities REIT, Inc. on Sept. 8, 2022, for approximately $300 million.

Diminished deal size

The five largest medical office building deals by dollar value, so far, in 2023 feature four from January and one that occurred in February. They include: 

    • Big Sky Medical Real Estate’s $190 million purchase of an 857,779-square-foot, 10-property medical office portfolio with locations in Texas, Maryland, Louisiana and California on January 11.
    • The purchase by Remedy Medical Properties and Kayne Anderson Real Estate of a 13-building, 300,328-square-foot medical office portfolio from Montecito Medical Real Estate on January 4 for $131 million.
    • The acquisition of Imperial Mariner, a four-building, 288,189-square-foot medical office campus in Brea, California, by Healthcare Property Advisors on January 4 for $80 million.
    • The purchase of The Offices at Vernon Manor, a seven-story, 156,000-square-foot building, and Offices @ Vernon Place, which consists of 147,130 square feet and is a four-story building, by Azora Exan for $78 million on January 31. Both buildings are fully leased by Cincinnati Children’s Hospital
    • The sale of a five-building, 179,000-square-foot medical office portfolio in Pennsylvania, Connecticut, Georgia and Texas to a state pension fund on February 28 for $72.7 million.

The top five medical office building transactions in 2022, based on disclosed price, were:  

    • Healthcare Realty Trust’s $18 billion acquisition of Healthcare Trust of America, Inc. on February 28, 2022. Healthcare Trust of America, Inc. was described as the largest dedicated owner and operator of medical office buildings in the United States, comprising approximately 25.3 million square feet of gross leasable area, with $7.5 billion invested primarily in medical office buildings. Healthcare Realty Trust is a real estate investment trust focusing on health care.
    • The acquisition of two multi-state medical office building portfolios that consist of 40 properties totaling 1.2 million square feet spanning Alabama, Arkansas, Connecticut, Florida, Georgia, Illinois, Indiana, Louisiana, Massachusetts, North Carolina, Tennessee, Texas and Virginia. National Real Estate Advisors, LLC and Catalyst Healthcare Real Estate were the acquirers on January 13, 2022, for $420 million.
    • The sale of an 11 medical office building portfolio that included locations in California, Texas, Maryland and Louisiana. The properties have a total of more than 1 million square feet. GFH Financial Group and Big Sky Medical made the purchase on October 12, 2022, for $400 million.
    • MedProperties Realty Advisors’ sale of a medical office building portfolio that consists of over 1 million square feet. Remedy Medical Properties and Kayne Anderson Real Estate Advisors, L.P. were the acquirers on February 15, 2022, for $350 million.
    • The sale of a 10 medical office building portfolio that consists of 661,000 square feet of space at buildings in Atlanta, Pittsburgh, Tampa and Dallas. Nuveen Global Cities REIT, Inc. was the acquirer on September 8, 2022, for approximately $300 million.

Concentrated on conversions

“The strong valuation of existing medical office product and the rising cost of new construction has spurred increased interest in conversions of general office to medical office,” Johnson said. 

“Conversion is an attractive option in certain situations, but there are many important factors to consider when evaluating a conversion, including floor-to-ceiling heights, floor rigidity, efficient floor plates, elevator sizes, emergency power generation, etc. Ultimately, these are basis plays where the goal is to acquire an asset at an attractive value, invest the required capital and, upon completion, the result is a nearly new medical office building at an all-in basis well inside what it costs to acquire a similar purpose-built medical office building or build a new medical office building.”

Johnson added that JLL’s healthcare partners indicated the need for medical office space won’t contract as much as might be expected due to telehealth and home care.

“The question is what real estate is needed to deliver care and how innovations such as home care and telehealth may affect the locations and amount of space needed. The underlying demand generators related to population remain strong and clinicians favor in-person interactions. Care operators, however, have become more disciplined about using space efficiently.”

Johnson added that in the current economic environment, many are scrutinizing space utilization and contribution to the bottom line as well as patient outcomes. The result has been an uptick in space consolidations and dispositions of previously underutilized space despite increasing demand for medical space overall.

Those searching for good news from the shrinking data can look at the fact that the single-digit percentage drop in medical office building deal flow so far in 2023 compared to the same period in 2022 isn’t comparable to the double-digit decline in the number of transactions in the overall health care sector.

Deals reported in all sectors this year totaled 1,698 through October 13. This represents a 14.7% decline compared with the 1,990 transactions posted during the same period last year. This year’s total of 1,698 is running 30.4% behind the 2022 full-year total of 2,441. The amounts reached 1,355 and 2,247 in 2020 and 2021, respectively.

“Demand for medical office buildings is driven directly by the demand for health care,” Hart said. “With continued advancements in medical care, resulting in longer lifespans, combined with an aging U.S. population, a phenomenon often referred to as ‘the silver tsunami,’ demand for medical care is on the rise. This has resulted in an influx of investors into the medical real estate space, many of whom are developers and work to increase the supply of medical office buildings via ground-up construction or conversion from retail or professional office.”

“The silver tsunami” refers to the fact that more than 10,000 people turn 65 every day in the U.S., according to the U.S. Department of Health and Human Services.

The AARP states the number of older adults will more than double over the next several decades to top 88 million people and represent over 20% of the population by 2050. The data may suggest any decline in medical office building deal activity could be temporary with transactions potentially rebounding in 2024.

Glenn Kalinoski is a writer for Levin Associates.

Levin Associates provides comprehensive coverage of the deals, companies, and trends shaping the healthcare industry. Clients have access to proprietary M&A transaction data and daily news & analysis through the LevinPro platform.

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