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THE ULTIMATE GUIDE TO INVESTING IN MEDICAL OFFICE BUILDINGS
EDUCATION
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Real estate has long been considered a great way for investors to diversify their portfolios and mitigate against the risk of stocks, bonds, and more traditional equities. Yet the medical office is often overlooked by real estate investors. Historically, the sector has had high barriers to entry. It is perceived as more costly, more complicated, and more niche of a product than other asset classes.
However, more investors are starting to add medical offices to their portfolios because the medical office continues to prove itself as a stable, recession-resilient asset class. As a result, tenants tend to be stable, rents increase, and yields remain strong relative to other real estate product types.
Medical offices also have an exceptional trajectory ahead. A combination of factors, such as more insured Americans and the aging of the Baby Boomer generation, is creating a sustained demand for medical office space. Unfortunately, this has created a significant supply-demand imbalance that is not expected to correct itself for the foreseeable future, given the lack of new MOB construction planned or in the pipeline.
Medical offices remain an excellent consideration for any investor looking to diversify their real estate holdings for all of these reasons.
Medical office space is distinctly different from traditional offices. These properties have been uniquely designed and often subdivided to accommodate a range of health care uses.
Medical office space has historically been on or near hospital campuses, given the referral patterns between physicians and affiliated hospitals. However, as more patients seek convenient care closer to home, medical offices are more prevalent in suburban and rural areas.
Medical office buildings can range from small, standalone facilities (1,000 square feet) to high-rise medical office buildings in urban areas.
Ownership of medical office space can take many forms. First, there are opportunities for individual owners to buy MOB buildings, which often happens when physicians elect to own real estate and then operate their practice from that facility. There are increasingly significant national buyers, like real estate investment trusts, who have added medical offices to their portfolios to greater diversification.
There is a lot more than price that determines the cap rate including proximity to campus, overall size, occupancy, credit worthiness of the tenants, guarantees, lease structure, lease term, annual escalations, and many other factors.
There are many reasons real estate investors consider adding medical office buildings to their portfolios. However, the primary benefits to investing in medical office vs. other product types include the following:
The health care sector is one of the fastest-growing industries in the nation regarding both demands for health care services and the need for health care workers. This makes the sector resilient and creates prolonged demand for medical office buildings. A medical office is a great option for risk-averse investors, given the industry’s strong underlying fundamentals. Medical offices, once considered a niche product type, actually proves to be less risky than other niche real estate investment alternatives – something the investment community is starting to realize only as of late.
Many prospective real estate investors witnessed their peers suffer devastating losses after the 2008 financial crisis. The breadth of new commercial real estate development leading to the market collapse left many investors with half-complete underwater projects. Given the ebbs and flows of any real estate cycle, including the uncertainty brought on by the COVID-19 pandemic, it should come as no surprise that many investors remain wary of investing in ground-up development projects.
One of the benefits of MOB investments is that new development is not necessary for investors to succeed. A majority of the transaction volume involves sale-leasebacks. For example, a physician-owned practice is looking to sell their property to an investment group, which will manage the real estate on the tenants’ behalf. Then that physician group will continue to lease from the new owner for a while. The popularity of MOB sale-leasebacks and lack of widespread new MOB development can help to mitigate investors’ risk.
Compared to other product types, it is not uncommon for the cap rate differential on medical office buildings to be 200+ basis points higher. For example, a retail or office property leased to a credit tenant or national brand may be considered “safer” from a risk perspective, but the corresponding returns are much lower. Investors who peel back another layer will find that MOB properties are relatively low-risk for the above reasons. Those who invest in medical offices are well-positioned to capitalize on this cap rate and yield arbitrage.
Investing in medical office space is not a decision that most people make without first understanding the nuances of the sector. Therefore, investors will want to consider five critical aspects of the medical office industry before making their first MOB investment. The top five things to know include the following:
Related: Moving Before the Market Does
Real estate’s oldest (and perhaps, most overused!) adage is: “Location, location, location!”. At the risk of being redundant, it is important to note how critical location is to the success of a medical office building.
Location matters in a few contexts:
First is the distinction between on- and off-campus MOB properties. On-campus properties refer to those that are located on or immediately adjacent to a hospital campus and, by extension, will often have a formal affiliation with that hospital. On-campus MOBs rely on the hospital’s referral network to drive their overall revenue and success. On-campus MOBs, for example, tend to receive higher health insurance reimbursements for treatments compared to the same treatments performed on an off-campus facility. As a result, many institutional investors will only consider buying on-campus properties.
There’s a growing demand for off-campus MOB properties, often referred to as “ambulatory care” facilities. Off-campus medical office buildings are generally located in areas that provide more convenient patient access. In addition, as the U.S. population ages, a growing number of people will be looking for easily accessible care closer to home. This increases the appeal of ambulatory care facilities.
A second locational consideration pertains to local demographics. MOB facilities located in densely populated areas tend to outperform their peers. Therefore, investors looking at alternative MOB investments may want to consider properties in areas like the “Sunbelt” states, such as Arizona, North Carolina, and Florida, with growing populations. Investors should analyze what’s driving that population growth by taking this one step further. For example, Arizona is attracting a disproportionately large share of retirees. As people age, their need for health care tends to increase, and therefore, areas with both an aging and growing population tend to be well-suited for MOB investment.
Finally, within a region, investors should also consider the specific location. Ideally, a medical office building will be in a highly trafficked area, visible from the road, excellent signage, and easy vehicular access and parking.
Investors will want to look at the tenant profile when considering a MOB opportunity. Specifically, is the tenant part of a physician group? Is it an imaging center? What are the tenant’s credit profiles and history in the local market?
Depending on what the tenant does, the investors will want to understand the barriers to entry into the local marketplace. For example, it is easier for an urgent care facility to open in an area than for an endodontist or orthopedic surgery group to establish a practice. Therefore, a building with the latter would generally be preferred over the former – at least, from an investor’s perspective.
Related to this is how much the tenant is paying on a price per square foot basis. Again, this will vary depending on the tenant occupying the space, market, and specific location within that market.
The size of the building will influence what type of investors will be interested in the property. For example, more extensive, multi-tenant medical office buildings will generally appeal to large, public investors (like real estate investment trusts) and larger private companies, like family offices. In addition, large, multi-tenant buildings typically require more intensive management, which is something for prospective investors to consider.
Alternatively, investors might lease a large property to a single tenant. Of course, there are pros and cons to this, as well. For example, suppose the tenant has a strong credit profile, good reputation, and long history in the community. In that case, there is probably little concern over the long-term viability of the tenant in that building. However, whenever a large property is leased to a single tenant, there is always a risk that the tenant leaves, experiences financial trouble, or in worst case situations, goes bankrupt. Therefore, investors looking at purchasing large, single-tenant MOB properties will want to evaluate how a worst-case vacancy scenario would drag down the broader investment portfolio.
The size of medical office buildings can vary widely. There are also much smaller, single- and multi-tenant properties with 5,000 square feet or less. MOB facilities like these tend to be purchased and sold by more locally based investors, including individuals and small investment groups.
Property obsolescence is a big issue for any commercial real estate investor, particularly for those considering a MOB investment. The healthcare industry is rapidly evolving and tenants, depending on their specialty, need to keep pace with these changes to remain competitive. This means their space needs to function well and be optimized to meet patient and provider needs. A MOB property with low ceilings, for example, may not be able to accommodate specific medical equipment that requires more clear height.
Older, more outdated properties are incredibly challenging when leased to multiple tenants. Properties that have been subdivided to accommodate multiple tenants are generally less efficient than properties designed with one tenant in mind. Multi-tenant MOB properties will often have more “dead space” – i.e., non-rentable space, like corridors and mechanical rooms – than single-tenant MOBs.
While more expensive to construct, newer properties tend to have more modern amenities, HVAC systems (i.e., better air quality), and accessibility features than older MOB properties. But, of course, there is a premium associated with each of these features. Still, that premium will often pay dividends over the long run compared to investors who buy outdated MOB properties that need significant upgrades.
Despite the perception that medical office buildings are highly specialized and unique, they are also quite adaptable. With a few exceptions (e.g., high-rise, on-campus MOBs), you can easily repurpose most tenant spaces for different healthcare specialties. Clinical spaces are generally standard and used by providers of all kinds.
Moreover, while it is difficult to convert traditional office space to a medical office, the opposite is not true. With a few modifications, such as capping certain plumbing or electrical service inputs, most medical office buildings can be adapted to traditional offices. A simple medical exam room, for example, can easily be cleared out and repurposed as a traditional office.
The adaptability of medical office buildings, both for a range of medical office uses, and their conversion potential for non-medical uses, is an often overlooked benefit to investing in the MOB asset class.
There are many factors driving demand for medical office space. These include:
A primary appeal to investors considering medical offices is that the sector is recession-resilient. Unlike other industries, like retail, hospitality, and even traditional office, medical office buildings provide access to a critical need: health care. Health care is a non-discretionary industry. During an economic recession, people can postpone going out to eat, buying new clothes, or getting a haircut. Technology has made it easier for people to work from home, which has also limited the need for many people to go into the office.
Health care is a different type of industry. People can only postpone medical care for so long. If someone is sick, they will go to the doctor, regardless of whether the stock market is up or down. Most Americans will find other ways to rein in their spending, but with so many people being insured, rarely will they postpone medical treatment.
Of course, nobody can predict the future in terms of both the economy and demand for specific types of real estate. However, most medical office properties are financed with debt on at least a 20-year amortization schedule. Real estate cycles historically last about ten years each. Statistically, this means that a MOB investor who purchases a property today will go through two real estate cycles during that amortization period.
Therefore, investors should consider how this property will fare amid potential economic fluctuations over the next 20 years. Given the steadfastness of the industry today, the next two decades look bright. If the past 20 years are any indication, most health care practices will continue to do well. Furthermore, demand for health care is expected to increase during this time. Therefore, anyone considering a MOB investment today can feel relatively confident that their investment will be able to endure economic ebbs and flows for the foreseeable future.
As evidence of MOB’s resiliency, one needs to look no further than how medical office buildings performed during the COVID-19 pandemic. Rent collections remained high despite a brief halt on elective procedures, which is a major driver of some MOB tenants’ revenues. According to data firm Revista, LLC, MOB landlords reported collection rates of over 95 percent during the depths of the pandemic. Moreover, the average price per square foot rent for MOB facilities increased 5.5 percent in 2020 despite the pandemic.
Related: What Business Leaders Can Learn From the Pandemic
Another way to look at MOB investments is how they have performed coming out of the worst of the pandemic (i.e., in a post-vaccination climate). Economists often point to a “K” shaped economic recovery, in which some asset classes rebounded quickly, and others continued to struggle or decline. Medical offices have performed at the top of that “K-shape,” outperforming most other asset classes, given investors’ positive sentiments about the sector.
One of the perceived challenges associated with MOB investments is that these buildings have more stringent building requirements than other real estate asset classes. While there are some differences between medical office buildings and traditional offices, these building requirements are not so cumbersome that investors should overlook them.
Building codes vary depending on where a property is located. This is true for any real estate type, not just medical offices. Usually, state and local (municipal) building codes dictate how property is designed, built, and operated.
That said, building codes do not vary significantly between traditional and medical offices. However, a code may dictate more stringent compliance with ADA accessibility, such as the availability of ramps, elevators, and handicapped-parking spaces. In addition, there may be enhanced stipulations around fire protection, depending on the specialties and uses within the property.
Otherwise, the most significant difference between a traditional and medical office usually pertains to parking.
Given the frequency with which patients and practitioners visit a medical office building, most codes require MOBs to provide a higher parking ratio than other users would expect. As a rule of thumb, medical office buildings should have at least five parking spaces per 1,000 square feet of development.
For a 100,000 square foot facility, this would mean at least 500 parking spaces; how these parking spaces are laid out also matters. In addition, some codes stipulate that the parking must be located within a distance of the building’s front door to limit the distance patients have to travel. Again, this can influence where a MOB project is located and how it is ultimately designed.
Medical office investors should anticipate building code revisions to require more stringent air quality standards as the COVID-19 pandemic has highlighted the importance of air circulation and proper ventilation.
Advances in technology have also influenced medical office building design. The most prominent shift has entailed the digitization of medical records. Historically, MOBs would need large, fireproof rooms where patient records could be kept for ten years, per statutory guidelines.
Recent changes to federal healthcare regulations allow these records to be stored online (in the “cloud”), which provides easier access for providers and reduces the need for these significant storage rooms. In addition, we can repurpose those rooms for other medical uses (particularly those that generate more revenue). In newly constructed facilities, investors can eliminate these medical record rooms.
Technology also influences the design and layout of MOB common areas, especially patient wait rooms. For example, the pandemic has forced medical care providers to rethink utilizing waiting rooms. Rather than having patients sit near each other, often for prolonged periods, some providers have used technology to page patients when their care team is ready to see them. This allows patients to wait outside, in a cafeteria, in their cars, or elsewhere rather than in a traditional waiting room. Widespread adoption of these practices will likely reduce the need for oversized waiting rooms, which will, in turn, impact the overall footprint of medical office buildings.
Related: How Technology is Accelerating Real Estate Trends
A third technological consideration is that many medical office equipment are becoming smaller and more mobile. This allows MOB offices to deliver more efficient patient care. Something like imaging, which used to occur in a hospital-like setting, can now be done in a MOB building, with remote technicians able to review the results off-site. Providing diagnostic care in a MOB building is expected to increase as technology advances.
Finally, technology’s impact on telemedicine cannot be overlooked. Telemedicine accounted for less than 5 percent of all patient visits pre-pandemic. However, it skyrocketed to more than 50 percent of health care visits during the depths of the pandemic during the spring of 2020. While telemedicine rates have since dropped, we expect its use to continue to some extent well after the pandemic ends. The impact this has on medical office buildings remains to be seen.
However, one could imagine that instead of reducing demand for in-person care, telemedicine will instead result in a net increase in the number of patient visits. Patients may have pre-screenings or other initial and follow-up appointments conducted by phone. However, most medical care requires patients to their provider, and telemedicine cannot simply replace this human interaction.
Increasingly, the materials used in medical office buildings are of higher quality than those used in older vintage MOB properties. For example, old industrial flooring has been replaced with more aesthetically pleasing laminate flooring. Incandescent light bulbs have been swapped out for more energy-efficient LED lighting. In larger buildings, particularly newly constructed ones, more attention is being paid to sustainability with features such as rooftop solar panels.
You can see the most prominent contrast in building materials at newer facilities geared toward private-pay patients, such as dermatology and plastic surgery clinics. These properties will often utilize especially high-end materials, such as crown molding and elegant fixtures. Often, these properties feel more akin to a hospitality property than a traditional or medical office building.
Acoustics is an increasingly important design consideration for medical office buildings, given the strict privacy standards required by HIPAA regulations. For example, any wall that separates a patient exam room and waiting room must be designed to a certain “sound transmission coefficient” per HIPAA regulations.
Managing sound is much easier in new buildings because we can utilize soundproofing materials in the build-out of each space. Moreover, more contemporary MOB facilities tend to be designed with more individual rooms instead of shared or open-air spaces where sound could more easily travel.
The design of MOBs is especially important, particularly as the costs to construct new medical office buildings continue to climb. As a result, medical office buildings must be designed more efficiently than ever before. This often entails smaller waiting rooms, fewer common areas, and the use of smaller doctor “pods” that are laid out to improve both efficiency and traffic flow within the building.
As more sophisticated investors have begun adding medical offices to their portfolios, the number of architects and engineers specializing in MOBs has also increased. These professionals will continue to advance MOB design to ensure buildings are optimally designed and generate the highest returns for investors—without sacrificing patient or provider needs).
Most prospective medical office investors will weigh a range of opportunities, including investments in on-campus vs. off-campus facilities and older, existing facilities vs. those that are newly constructed or still in development. While any MOB investment can prove profitable, there are seven distinct reasons for investors to consider buying a new building rather than one in need of improvements.
Recently constructed MOB properties are more reflective of a shifting development model that prioritizes ease of access and convenient patient care. These properties are designed with the patient experience in mind. For example, new properties are often designed with more amenities than standard MOB buildings and may feature things like floor-to-ceiling windows and walking paths around the property – features intended to promote patient health and wellness.
New MOB properties are also designed to be more efficient, something that is of growing importance to MOB investors and tenants alike. As the costs to construct MOBs rise and as rent costs correspondingly escalate, the efficiency of space is more critical than ever. New buildings can be optimized more effectively than older medical office space.
Newer medical office buildings are more complex in the sense that they are more technologically sophisticated. They will often have high-end, elaborate security systems, carefully planned fire suppression systems, and more ADA-accessible features. However, the tradeoff for being more complex is that newer MOBs are also more efficient, as described elsewhere above.
New MOB properties are designed to accommodate a range of technological improvements, such as mobile kiosks, freestanding nursing stations, and on-site diagnostics. The digitization of various building elements and equipment allows for providers to concentrate care in a single area within that building rather than having patients travel from one wing to another, or worse, from one building to another. These increasingly digital buildings make specialties more efficient, ranging from how cancer treatments to dialysis are delivered.
New medical office buildings are more efficient than ever before. The modern-day MOB facility can operate significantly leaner than its predecessors through various technologies, improved building materials, and exceptionally efficient HVAC and other building systems.
The efficiency of new MOB properties should not be overlooked by investors, especially from a cost perspective. Many investors contemplate purchasing an older MOB property with the intent to execute a value-add strategy. The costs of doing so can be exorbitantly high. The cost to renovate an outdated MOB often meets or exceeds the costs of simply building ground-up given the inefficiencies of older buildings (e.g., big skylights, wide corridors, excessive non-rentable space).
As the American population ages, more people will be seeking care closer to home. This is especially true among the Baby Boomer generation, who need more frequent medical care and want easy access to that care. They do not want to go to big, urban areas where they are forced to fight traffic and circle for parking. The urban, high-rise medical office building simply no longer appeals to older Americans as they age.
This creates an opportunity for MOB investors who are looking at newly constructed properties, many of which tend to be located in more conveniently located suburban and rural areas in response to patient demand. Medical offices are also being integrated into more traditional retail settings, many of which were originally designed to allow high-volume vehicle and foot traffic, making MOB properties successful.
All newly constructed real estate tends to be “greener” than older buildings, but this is especially true of medical office buildings. New MOBs must meet stringent building and energy codes. In some cases, new medical office developments are required to be at least LEED Silver, or LEED Gold certified.
In order to meet these standards, medical office buildings now feature an array of sustainable elements starting on the exterior with more sustainable, native landscaping, triple-glazed windows, and often, solar panels or geothermal systems designed to save heat and energy. Inside, new MOB facilities will generally have modern, highly efficient systems that allow for better climate control. Lighting is also improved, materials are more durable (and therefore, need to be replaced less frequently), and water usage tends to be lower.
As noted above, new medical office buildings are generally more aesthetically pleasing than older MOBs constructed in the 1970s or 1980s. Windows are larger to allow for greater light penetration. They use higher-end materials and finishes. Waiting rooms and lobbies are designed to feel more like hospitality or retail setting than a traditional medical office.
There are many reasons for the aesthetic improvements, but namely, these changes are being made in response to patient demand. MOB operators and their tenants place great emphasis on creating an exceptional patient experience.
As the demand for medical care grows, providers want to be sure they can attract and retain their patients. Whether consciously or not, most patients prefer to see a provider in a newer, more comfortable facility than a provider was operating out of a darker, less visually pleasing environment.
To be sure, a medical office is a unique real estate asset class, but those who understand its drivers will find that it is a relatively low-risk investment compared to other real estate product types.
Moreover, the medical office is still a burgeoning industry. A sector once perceived to have impenetrable barriers to entry is now available to investors large and small. There are a growing number of ways to invest in small, standalone MOB properties as well as more established, institutional-quality medical office buildings. The sheer variety of medical office properties makes it appealing to investors of all kinds, risk tolerances, and geographies.
While medical office buildings require hands-on management, there are many ways to invest alongside an adept MOB sponsor passively. Anyone who is looking to grow their passive income will certainly want to pursue this approach, which will ensure the day-to-day is being managed effectively on their behalf.
Ready to start investing in medical offices, add diversity to your portfolio, and earn passive income from the MOB market? Learn how Alliance can help.
Join us for an exclusive webinar on July 31st at 4 PM PT to learn about investing in our Alliance Medical Fund.
