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Real estate investors looking to diversify their portfolios are increasingly considering medical office properties. Once considered a relatively niche sector, medical office buildings (or “MOBs”) have drawn interest from a new pool of investors. Some have seen, yet again, that the sector holds its value even during the depths of an economic crisis.
Many factors make medical office buildings recession-resistant, several of which we look at today. The ongoing strength of these properties makes them a relatively safe, low-risk alternative for those looking to grow their real estate holdings. This is especially true given the typically high-cash yields that healthcare real estate generates compared to other real estate sectors with similarly low-risk profiles.
Over multiple real estate cycles, medical office buildings have proven their ability to combat fluctuations in the economy. In turn, this is driving significant investment dollars to the industry, especially among real estate investors who want to invest in more stable sectors while still achieving considerable yield compared to other asset classes.
There are several reasons why medical office buildings continue to be recession resilient. Namely, MOBs tend to provide critical health care services. While someone may be able to postpone getting a manicure, pedicure, or haircut during a recession, they can only put off medical treatment for so long.
Moreover, many U.S. consumers now have health care insurance – either public or private – making medical care more attainable. Being insured helps to mitigate the need to postpone a health care service due to the costs that may otherwise burden someone’s pocketbook in a down economy.
A third reason for the sector’s resiliency pertains to shifting demographics. As Americans grow older, their need for health care services increases. For example, someone in their 20s might only see a doctor once every year or every other year. Those aged 65 and above tend to see the doctor upwards of seven or eight times per year (and often more). According to the U.S. Census Bureau, roughly 10,000 Americans turn 65 each day, which has strengthened demand for MOB properties of all types and in virtually all locations.
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The medical industry, in general, is a fast-growing industry. This is chiefly due to the trend noted above on America’s aging population. As the Baby Boomer generation ages, they place greater demand on the current healthcare infrastructure. This has led to a shortage of doctors and nursing staff in some areas. The medical industry is working hard to expand its infrastructure to meet the growing demand. According to the U.S. Bureau of Labor Statistics, approximately 3.2 million healthcare-related jobs will be created over the next eight years, with 20 of the fastest-growing professions in the country being part of the medical field.
More medical office buildings will need to come online to support this growth, and demand for existing facilities will continue to remain strong. Get in touch with the commercial real estate experts at Alliance to learn more about this profitable investment opportunity.
In addition to being recession-resistant, there are two other reasons why medical office space makes a significant investment.
The first pertains to investors’ ability to underwrite supply and demand. Industry experts can reasonably forecast the market for outpatient care based on historical patient needs and demographic trends. For example, in an area with solid population growth, particularly among those aged 65 and above (e.g., the Sunbelt region), an investor can analyze the existing MOB inventory, the quality of this inventory and its vacancy rates, and then assess the level of demand for future medical office space. This is especially effective when investors have a keen awareness of industry trends and can analyze the specific specialties or services in most significant demand, and can then build facilities suited to meet practitioners’ needs.
Those who become familiar with MOB underwriting are well-positioned to take advantage of the industry’s growth. Understanding the demand side of the equation is especially important for passive investors looking to mitigate risk.
A second and related factor is that MOB demand is projected to outpace existing supply in most regions. The risk of new construction is mitigated by the exorbitant costs of new construction, as labor and material costs have skyrocketed in recent years. This means that a doctor who once leased space for $20 per square foot might be looking at rents closer to $40 per square foot at a newly-constructed ambulatory care facility.
As costs for new MOB properties escalate, there will be enhanced demand for existing facilities. Even those built just five or six years ago will lease for a fraction of the price of new buildings, which will be attractive to many healthcare specialties as they evaluate their lease options and look to grow their bottom lines. Many physicians will opt for a lower cost of occupancy when presented with these options. Therefore, investors who own existing facilities may have a competitive advantage in the MOB space for the foreseeable future.
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Medical office buildings also appeal to physicians looking to own or co-invest in their facilities. This is because the overhead costs associated with necessary equipment are pretty low, simply because most physicians have the opportunity to lease the equipment rather than purchase it outright. This lowers the upfront capital costs of owning MOB space, and by extension, lowers the barrier to entry for those looking to invest in medical office properties.
Many physicians will also invest in an MOB property alongside other physicians, primarily when they are affiliated with an extensive practice that wants to maintain its independence from the local hospital systems. By investing in their property together, the physicians can take advantage of insurance and other cost savings. Together, they have better-negotiating power which results in a more profitable MOB facility.
Whether the property is owned by a group of physicians or an investment firm, the owners must maintain the building regularly to keep overhead costs low. This sometimes proves to be a challenge in situations where the property is owned by a group of aging physicians who are on the verge of retirement. Rarely do physicians remain co-owners of a property after selling their practice and retiring.
Instead, they will generally look to the next generation of up-and-coming physicians to whom they can sell their MOB investment stake. This transition from one generation to the next becomes significantly more complicated if the building has not been adequately maintained. This can result in costly capital expenditures that prospective investors may not be willing to entertain.
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Yet another reason medical office continues to be recession-resilient is that MOB tenants are considered “sticky.” In other words, these tenants are not as likely to up and move as traditional office tenants might be. This is because physicians invest heavily in their business, both from a physical perspective (building design, layout, features, equipment, and more) and in terms of building a brand and establishing a reputation within the community. Once a physician has put down roots in a community, they are unlikely to relocate elsewhere unless under extraordinary circumstances.
Therefore, investors looking to purchase MOB properties, especially those at or near full occupancy, will find comfort in having tenants who are likely to be on long-term leases. This reduces tenant turnover and reduces the risk of disruptions in cash flow between tenancies.
Of course, every tenant is unique and should be evaluated individually. What’s more, not only are physicians considered to be “sticky” tenants, but they also tend to be very credit-worthy tenants. That said, even during the depths of the COVID-19 recession, when some medical procedures were forced to be put on hold, rent collections at medical office buildings remained strong, and turnover was low.
One factor driving competition for medical office buildings is the lack of current inventory. Compared to other commercial real estate product types, the industry remains a niche sector. There is roughly $10 billion in MOB sales volume per year on average. Less than half of this is directly linked to net-lease health care sales.
Moreover, the pool of potential buyers is both diverse and deep. It’s not uncommon to have 10 or 15 bidders on any given property. Individual investors are looking to buy MOB properties as part of a 1031 exchange. Private equity funds are focused on acquiring and aggregating these assets before a wholesale recapitalization of the portfolio. At the other end of the spectrum are institutional REITs focused on the health care sector for decades and seek to continue growing their portfolios. This puts pressure on an industry with very little new product coming online, which drives up the price for existing MOB properties.
As competition for medical office properties increases, more institutional investors and large private equity groups are entering the space in record numbers. They are buying MOB properties traditionally physician-owned, which has allowed longtime physicians to retire without maintaining the burden of managing the real estate. Sometimes, an MOB investment group will purchase many standalone properties and, after achieving scale, will re-brand those properties under a new name or identity.
With competition rising, investors should expect medical office cap rates to compress. This is a trend that has already begun. Historically, cap rates, which used to be closer to 8 or 9 percent, are now more comparable to 6 or 6.5 percent in most major markets. There has been a nearly 100 basis point compression over the past twelve months alone, highlighting the rapid uptick in medical office interest among real estate investors.
In some markets, properties will sell at a 5-cap, which is increasingly common for well-located, on-campus properties tied to an extensive health system and/or have a long-term, credit-worthy tenant in place. Investors are paying well upwards of $225 per square foot for MOB properties like these. And that still proves to be a bargain compared to the cost of acquiring newly-constructed properties built today (and similarly, compared to the cost of building a new MOB facility, which can quickly run $300 per square foot today).
For investors to compete in today’s MOB marketplace, they must be competitive on both price and terms, but they must also have or show a willingness to create a good relationship with the current tenant(s). Sellers will want to know that the buyer has a proven track record of working with medical office tenants, including both physician practice groups as well as hospital systems. In fact, this is usually the best way for a buyer to stand out in an otherwise crowded field who otherwise all have the same amount of money they are looking to invest.
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The traditional banking system has a strong awareness of the healthcare field, its drivers, and the demand for medical office properties. Lenders understand how physician practices operate, generate revenue, and the typical rent obligations associated with running a healthcare practice.
This makes MOB buildings relatively easy to finance compared to other niches in real estate asset classes, increasing the appeal of medical office properties.
To be sure, the specifics of any MOB property will drive how recession-resilient they prove to be, which is an essential consideration for investors considering this property type. But as a general industry class, MOB has helped investors avoid the dramatic ebbs and flows they might experience with other investment alternatives.
Anyone looking to invest in the space, or existing owners of MOB properties, will want to monitor healthcare trends closely. This includes paying close attention to the technological advances driving industry changes and the demographic directions creating demand for specific specialties in different geographies.
Increasingly, even the most sophisticated real estate investors are making missteps when investing in medical office properties. This comes as a result of not knowing the nuances of the sector. To hedge against that risk, investors should consider supporting alongside an experienced operator to secure the correct type of MOB facility.
Alliance is a commercial real estate investment firm. We make it easy to get your foot in the door with high-quality medical office building investments. Get started today!
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