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The healthcare industry is one of the nation’s fastest-growing industries and today compromises an estimated 20% of the national GDP. This isn’t lost on real estate investors. Once considered a niche market within the commercial real estate sector, healthcare real estate is gradually becoming a core asset.
Nevertheless, many real estate investors are hesitant to enter the market due to the specialized knowledge needed to be successful in the field.
This article looks at what’s driving investor attention toward healthcare real estate and why it is an asset class that every real estate investor should consider adding to their portfolios in some form or fashion.
Many people associate healthcare real estate with hospitals when healthcare real estate is a much broader asset class. Healthcare real estate comes in many shapes and sizes, ranging from hospitals to outpatient clinics and even local doctors’ and dentists’ offices.
Medical office buildings are one subset of healthcare real estate. Medical office buildings are generally classified as either on-campus (located on a hospital campus) or off-campus (further afield from a standard hospital). In addition, they can be either hospital-affiliated or entirely independent.
In short, healthcare real estate is any commercial property that caters to businesses and organizations operating in the healthcare industry.
Historically, hospitals would own their on-campus real estate, primarily when those properties were located in urban settings. However, as healthcare costs have risen, hospitals have faced growing pressure to focus on their core business – i.e., healthcare, not real estate. This has led many hospitals to sell off or otherwise monetize their real estate assets. Like hedge funds and pension funds, institutional investors are the typical buyers of large hospital campuses, which they then lease back to the healthcare organization.
At the same time, the non-hospital affiliated medical office buildings, typically owned by the physicians’ who occupy the property, are now becoming attractive among mid-sized and retail investors. The physicians who have owned these buildings since the 1980s and 1990s are now beginning to retire. They are leveraging the equity they hold in these properties and are starting to sell to investment groups, often at a premium. They use the sales proceeds as a cushion as they head into retirement.
These are just two examples of healthcare real estate and investment opportunities. There are many others. The healthcare industry is at a pivotal moment where, on the one hand, hospital systems are acquiring smaller mom-and-pop physicians. On the other hand, there’s a push for building medical office space in suburban and rural locations – areas located more conveniently to where people live. These dueling forces are reshaping the future of healthcare real estate, creating opportunities for all investors.
America’s aging population is the primary driver of demand for healthcare real estate. The Baby Boomer generation is entering their retirement years. By some estimates, there are 10,000 Americans turning age 65 each day. As people age, they inherently need more medical care. For example, someone who saw their doctor once or twice a year in their 20s and 30s may visit the doctor 10+ times per year as they approach retirement age.
Consider this: healthcare spending, on a per-person basis, among those aged 65 and above is consistently five times higher than that spent per child and three times higher than that spent per working-age person.
What’s more, the care that people need as they age tends to become more specialized. As a result, people begin seeing various specialists – from cardiologists to orthopedic surgeons, gastroenterology to oncology, and more. Few people see a specialist just once; they often have multiple visits before a diagnosis is made or before any treatment begins.
As more people need more frequent medical care, there’s a push to bring these services closer into the communities where people live. Retirees, especially, would rather avoid traveling into dense, urban areas for their appointments. This is particularly true if it requires navigating complicated parking garages and large hospital campuses.
Generation X, the second most prominent user of healthcare services, also prefers convenient, outpatient settings. With two-income families becoming the norm, the time has become more precious. They see enormous value in being able to bundle their healthcare visits into single, convenient locations. They seek out facilities to take care of routine exams for all family members, lab work, diagnostic imaging, urgent (often nighttime and off-hours) care, and pharmaceutical needs, all at a single location.
The preferences of these two user groups – Baby Boomers and Gen X – is driving demand for suburban medical office complexes. It’s also creating new demand for ambulatory care facilities (hospital-affiliated or not) that can be a hub for all patients’ needs. This “hub and spoke” model of healthcare delivery is a trend that has sparked the interest of investors who see these new ambulatory care facilities as a way to create both operational and cost savings that help to maximize investor yields.
Another reason investors are looking at healthcare real estate is due to how well it has and continues to perform during periods of economic uncertainty.
During the most recent COVID-19 crisis, vacancy and rent collections remained strong at medical office buildings. For example, according to data firm Revista LLC, medical office landlords reported collection rates in excess of 95% even during the worst of the pandemic. Omega Healthcare Investors, a national healthcare REIT, reported rent collections in excess of 99% while yielding a healthy 7.07% dividend as of mid-2021.
Medical office sales volume also remained strong during the pandemic. Whereas sales volume for all commercial real estate dropped 32% in 2020 compared to the previous year, medical office buildings continued to see robust activity. Investors purchased $11.2 billion worth of medical office buildings in 2020, only a slight dip compared to the $12 billion that traded hands the year prior.
Moreover, medical office rents are not prone to major peaks and valleys the way other real estate asset classes tend to be. Medical office buildings provide consistent income with moderate, 2-3% rent increases annually on average. In some markets, where demand for healthcare real estate is especially strong given demographic changes (e.g., the Sunbelt states), year-over-year rents have increased upwards of 6% or more.
Healthcare real estate is also attractive given that the tenants tend to be both very creditworthy and “sticky”.
Regarding the former, few healthcare tenants end up in default, especially given their ability to be reimbursed by health insurance providers.
Regarding the latter, most healthcare providers invest heavily in their space, their communities, and the initial marketing and branding needed to amass a network of patients in the area. Once physicians become established in a certain geography, their preference is usually to stay put. It’s not uncommon for the tenants of medical office buildings to sign mid-to-long-term leases, with some occupying space for 20+ years. This provides building owners with both predictability and stability, something that is hard to come by among other real estate asset classes.
The industry’s strong underlying fundamentals – ranging from high demand to low supply, with rent growth increasing and demographics that support sector expansion – have led more than 80% of healthcare REITs to say that medical office buildings are essentially “recession-proof.”
In addition to all of the points mentioned above – e.g., favorable demographic trends, sector stability, and recession resiliency – investors have other reasons to consider adding medical offices to their real estate portfolios.
One reason to consider investing in medical office space is that it provides portfolio diversity. Most investors are overwhelmingly invested in some combination of stocks and bonds. Few have a substantial portion of their portfolios invested in alternative asset classes. Among those who do, only some will have invested in commercial real estate. The number of people who have invested in healthcare real estate specifically is even less.
Yet there is good reason to invest in medical office space. Healthcare real estate is certainly a niche sector, but it allows investors to mitigate the risk associated with being overly concentrated in traditional stocks, bonds, and equities. Real estate investors, specifically, can mitigate risk by adding healthcare properties to their portfolios alongside investments in more traditional CRE sectors like multifamily, office, and retail. As many experienced first-hand during the recession, being overly concentrated in one product type (e.g., office or retail as of late) can drag down an otherwise promising portfolio as market conditions evolve.
Although there is strong demand for healthcare real estate, various state and municipal regulations keep these properties from being overbuilt. In some states, hospitals looking to expand their healthcare real estate must first get regulatory approval that shows sufficient demand for these properties (referred to as a “determination of need” process); they must also prove that expansion will not unduly increase healthcare costs.
Meanwhile, municipal regulations often prohibit healthcare real estate from being developed except in areas explicitly zoned to allow for medical uses. Prospective developers often face weary residents concerned about how these facilities will impact local services—e.g., additional demand for the fire department and ambulatory transfers.
Healthcare real estate is already a niche that rarely gets built on a speculative basis. Most developers will only propose a new medical office complex if they have a tenant ready and willing to sign a substantial, long-term lease. That, combined with various regulatory hurdles, ensures that the supply of healthcare real estate is likely to remain constrained for the foreseeable future despite growing demand. This bodes well for investors looking to add medical offices to their portfolios, as the supply shortage will (and has already) led to higher rents and pricing at existing facilities.
Given how difficult it can be to build new medical office space, another alternative is for investors to consider retrofitting other underperforming real estate assets into healthcare real estate. This is an increasingly popular trend among those who own big box and retail strip centers, given the challenges faced by the retail industry as of late. Adapting retail properties for medical office use is an opportunity for investors to capitalize on speed to market vs. new, ground-up medical office development.
By some estimates, more than 50% of the nation’s medical office buildings are at least 20 years old. Some of these buildings continue to perform well and, with strategic upgrades and renovations, can continue to deliver environments that support excellent care. Others, though, are on the verge of becoming functionally obsolete. For example, they have no room or capacity for upgraded technology, wiring, and medical equipment. Some floor plates aren’t conducive to medical practices today. Others don’t have sufficient parking or are at risk of building code violations.
Properties in physical decline present an opportunity for yield-seeking investors willing to take on value-add investment opportunities. With thoughtful planning, many of these otherwise outdated medical office buildings can be reimagined for 21st-century use well into the future.
Healthcare real estate is a sector that should be on every real estate investor’s radar. It is a highly desirable investment alternative and increasingly stable market sector – especially when compared to traditional office, retail, or hospitality.
Are you ready to invest in medical office real estate? Contact us today to learn more about how to get started.
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