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Cap rates may be compressing among certain real estate product types, but that has not kept investors on the sidelines. Instead, more investors are looking for alternative ways to invest in commercial real estate. Many are finding medical office buildings to be a highly attractive addition to their portfolios.
Medical office buildings were once an afterthought for many real estate investors, but now, especially in the wake of the COVID-19 pandemic, there is a heightened awareness about how integral these facilities are to our everyday lives and communities. Macro trends are also highly favorable for the medical real estate sector, with demand projected to increase significantly in many regions of the US. The vast array of these types of facilities, which can be as small as 1,500 square feet or more than 100,000 square feet, create opportunities for real estate investors of all kinds.
In this article, we look at why medical offices should be in every real estate investor’s portfolio.
Related: Changing Demand Trends in Residential Real Estate
A medical office is a subtype of a traditional office that, as you might expect, is tailored toward those in the medical field. “Medical” encompasses several uses, from doctor’s offices to dentists, medical laboratories like MRI facilities, to outpatient clinics, and even veterinary offices.
Medical office buildings, often referred to as “MOBs,” are distinctly different from ambulatory surgery centers, rehabilitation centers, and long-term acute care facilities.
That said, many medical offices are affiliated with hospitals. In recent years, large medical providers have begun extending their reach into communities by investing in standalone medical office buildings, acquiring smaller physician practices, and branding those facilities with their hospital affiliation. A hospital affiliation is not required, however. There are still many independently owned and operated medical offices occupied by physicians and other medical professionals who have their own practices.
Medical offices are usually distinguishable by their unique buildouts, specialized equipment, and patient facilities. For example, medical offices will generally feature a combination of traditional offices and exam rooms. They might have a patient waiting area instead of a more traditional office lobby. Lighting, HVAC, and other equipment are typically tailored to meet the specific needs of the medical practice operating within.
Medical office buildings may be designed to accommodate one tenant. Still, often these facilities have several medical users operating (no pun intended!) side-by-side as part of a larger healthcare-oriented complex. Medical offices may also be located within buildings with more traditional office or retail users.
Investors are increasingly drawn to medical office investments. There are several reasons for this, as we examine below. What was once a relatively overlooked real estate subtype has recently become front and center in the wake of the pandemic, as more people seek out medical services for both routine care and elective procedures.
Unlike other real estate product types, like a traditional office, retail, and hospitality whose demand ebbs and flows based on economic conditions, medical offices are largely cycle-resilient. MOBs are occupied by medical professionals who continue to see patients day in and day out, regardless of market conditions. Doctors, for example, still see patients for routine care like eye exams and physicals. People still go to the dentist for cleanings, fillings, and root canals, no matter the unemployment rate. People continue bringing their pets to the vet whether the economy is good or bad. In other words, medical care is an essential service that cannot be put on the backburner. In turn, MOBs are not as subject to market
disruptions the way other real estate asset classes tend to be.
The pandemic offers proof. There was a brief decline in demand for MOB space in the early days of the pandemic, especially when non-emergent outpatient services were suspended in some areas. However, shortly thereafter, demand ramped up again, and MOB tenants are now working their way through a backlog of patients looking to schedule both elective procedures and routine exams after having deferred care last year.
Medical office investments are also attractive to investors who are seeking portfolio diversity. In general, commercial real estate is a great way for an investor to diversify away from more traditional stocks, bonds, and equities. However, among those who already invest in real estate, adding a medical office provides even greater diversification. Medical offices, as noted above, offer stability regardless of where we are in any market cycle. Many investors will find that while their other real estate assets may decline in value during recessionary periods, medical office values continue to hold steady due to consistent demand from patients seeking medical care. Investors looking to mitigate portfolio risk will find medical office investing to be a relatively “safe” addition to their portfolio as they assess various diversification strategies.
Related: Are You An Investor or a Gambler?
Another benefit to investing in medical office space is that the tenants are inherently “sticky.” This means that it is difficult for tenants to relocate, which can be the case for any number of reasons. For example, most independently owned medical practices invest heavily in building their patient base. Once rooted in a community, few want to move elsewhere.
Moreover, the actual process of moving a medical office is challenging. Specialized equipment, from exam tables to imaging equipment, is heavy and difficult to relocate physically. Medical offices often have costly, complicated, and highly tailored buildouts. Having gone through this process once, most physicians do not want to relocate and go through the buildout process again (at least, not for many, many years).
In turn, medical office tenants tend to sign long-term leases for their space, giving them both predictability and certainty. This is especially true in an ever-changing regulatory environment where physicians face uncertainty about insurance reimbursements and other potential costs. The uncertainty associated with healthcare reform incentivizes healthcare providers to stay put—few want to “rock the boat” with a costly move when there are still many regulatory unknowns on the horizon.
MOB investors, meanwhile, benefit from having fewer (if any) tenant turnovers on an annual basis. On average, more than 80% of medical office tenants renew their leases each year.
Cap rates may be compressing among certain real estate product types, but that has not kept investors on the sidelines. Instead, more investors are looking for alternative ways to invest in commercial real estate. Many are finding medical office buildings to be a highly attractive addition to their portfolios.
Medical office buildings were once an afterthought for many real estate investors, but now, especially in the wake of the COVID-19 pandemic, there is a heightened awareness about how integral these facilities are to our everyday lives and communities. Macro trends are also highly favorable for the medical real estate sector, with demand projected to increase significantly in many regions of the US. The vast array of these types of facilities, which can be as small as 1,500 square feet or more than 100,000 square feet, create opportunities for real estate investors of all kinds.
Related: Changing Demand Trends in Residential Real Estate
Medical office tenants tend to provide landlords with predictable revenue streams. This is largely due to the “sticky” nature of medical office users who tend to sign long-term leases. It is also because physicians, doctors, and other medical providers tend to have strong credit and are reliable lessees.
During the depths of the pandemic, when elective procedures were canceled and some patients deferred routine care, many physicians’ offices experienced a brief interruption in cash flow. However, most tenants continued to pay their rent on time. According to data firm Revista, MOB landlords reported collection rates in excess of 95% throughout the pandemic. Moreover, the average price per square foot in rent for MOB buildings increased 5.5% in 2020, despite some facilities having to scale back or halt care momentarily. Unlike other asset classes, very few medical office buildings had to close entirely as a result of COVID-19 (and those that did may have done so for reasons other than the pandemic).
Now, with pent-up demand among patients who delay care, medical office tenants will be especially well-positioned to pay their rents on time moving forward—which creates more predictable revenue streams for MOB owners and investors.
Medical office buildings are difficult to build and develop. Despite these facilities being in high demand, there has been relatively limited new development over the past decade. For example, the pipeline for new, purpose-built MOB facilities currently under construction nationally totals less than 1% of the existing MOB building stock.
On average, only 20 million square feet of new MOB construction occurs annually across the US – a number that is starting to trail demand. Absent significant new construction, medical office supply will continue to be constrained.
One of the reasons for this is that permitting medical offices requires special approvals. Depending on the tenant(s), the user may need regulatory approval from state or local public health departments. For example, hospital-affiliated tenants may have to undergo a “determination of need” process that shows there is demand for their expansion and will not adversely impact patient healthcare costs.
Meanwhile, MOB hospital developers tend to be very disciplined—most will not build on “spec.” Instead, they will wait to begin a new project until they know that a substantial healthcare tenant (or several smaller tenants) is ready to relocate. This process takes time and is one of the reasons construction of new MOB facilities often lags the construction of other product types.
The challenges associated with building new MOB facilities have caused some real estate investors to adapt traditional office and retail facilities to medical offices. This process is by no means easy either, as a medical office has specific building requirements that must be met during the renovation process (e.g., specific HVAC systems that may increase the need for shaft space, adequate power, and life safety redundancy, enhanced ADA accommodations like ramps and elevators).
While conversions may increase supply to a degree, the pace of these conversions is still well below what’s needed to meet existing demand.
Limited competition, as noted above, bodes well for MOB investors, as it drives occupancy rates at existing facilities.
Evidence supports this. Medical office occupancy rates continue to remain strong nationally. The vacancy rate at MOB facilities was only 8.6% in Q4 2020. This represents a decline from the 10% historical average over the past decade, and again, proves that medical office investments remain stable even in the wake of widespread economic volatility.
MOBs were experiencing strong absorption rates pre-pandemic, as well. In fact, the absorption rate for medical offices (16%) was outpacing traditional offices (< 12%) between 2009 and 2019, a trend that will become even more pronounced as traditional offices continue to recover.
There are tremendous tax benefits associated with owning commercial real estate, generally, but there are specific benefits associated with investing in medical office properties. For example, most commercial properties can be depreciated over a 39-year period, the “useful life” of a commercial building according to the IRS. However, medical office buildings contain highly specialized (and expensive!) equipment that can often be depreciated faster through what’s known as a cost segregation study.
With a cost segregation study, medical office owners can segregate the costs of building components that are incurred directly for patient care. These costs can be depreciated faster than other building components, often in as few as three to five years. This allows the owner to front-load their depreciation, taking a write-off worth anywhere from 25 to 40% of the building value in the first few years of ownership.
The depreciation deduction is a “paper loss” that can be used to offset rental income, thereby putting more money back into investors’ pockets sooner than if they were to take traditional, straight-line depreciation over the 39-year period.
Medical offices are also appealing to investors, given demographic trends. The Baby Boomer generation (those born between 1946 and 1964) is aging and increasingly needs medical care. By 2030, more than a fifth of the US population is expected to be over 65 years of age. This is the age when demand for medical services tends to increase the most, and with people living longer than ever before, there will be prolonged demand from this demographic alone.
This bodes well for MOB investors.
As healthcare systems extend their reach into suburban and rural areas, this creates demand for smaller, standalone MOB facilities. MOB practices also offer lower-cost care than that provided in a hospital setting, accelerating the pace of new offices as insurers push for lower healthcare costs and appeal to patients paying out of pocket.
The number of insured Americans is also on the rise. Under the Patient Protection and Affordable Care Act signed into law in 2010, more than 32 million additional Americans gained healthcare insurance – an increase of more than 11% of people.
Medical office investing is a unique niche that is often overlooked by the masses. Yet, the sector has an incredibly positive outlook that is starting to draw attention from investors of all kinds. Institutional investors are largely drawn to larger, hospital-affiliated properties, but with the proliferation of smaller, standalone and physician-owned practices, there will be growing opportunities for retail investors at all scales.
Now is a great time for investors to consider adding medical offices to their portfolios. On the surface, a medical office investment might seem like a less glamorous alternative to newly constructed multifamily or industrial. Still, it’s proven to be real estate’s “steady Eddie” that provides diversification and stability.
Interested in learning more? Contact us today to explore whether our medical office investment opportunities would be the right fit for your investment portfolio.
Related: Investors Who Focus on Loss Aversion Will Fall Behind
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