CRE Midwest

Medical office property market reflects changing healthcare demand and delivery

Gino Lollio

Nationwide, policy changes such as the continuing rollout of the Affordable Care Act and demographic shifts are boosting demand for medical office space.

By Gino Lollio & Scott Niedergang, Associate Vice Presidents Investments, Marcus & Millichap Healthcare Real Estate Group, Chicago

Nationwide, policy changes such as the continuing rollout of the Affordable Care Act and demographic shifts are boosting demand for medical office space.

Many analysts predicted a slowdown in 2014 for medical office sales, in light of the fact that 2013 was a record-setting year, and that the fourth quarter of 2012 was particularly strong as owners rushed to close deals ahead of the January 1st increase in capital gains taxes.

And while there has been a lessening in the recorded volume of medical office property sales in the 1st half of 2014, recent large portfolio sales and a robust pipeline of pending contracts indicate demand for the product throughout the country remains high and pricing continues to be strong.

Why? One reason is the enactment of the Affordable Care Act. Government forecasts predict the ACA will reduce the uninsured, non-elderly population by 14 million individuals in its first year alone. In the coming years, an expansion of health insurance coverage is expected to substantially increase demand for medical services.

Another factor is the demographic reality of aging of baby boomers entering their traditional retirement years. The segment of the population aged 65 years and older, which accounts for an outsized share of all doctors’ visits and for an estimated one-third of U.S. healthcare expenditures, will grow by 17 million individuals over the next 10 years.

These factors are combining to impact the evolution of the healthcare sector. The resultant shift is to a more patient-centric delivery model which encourages an off-campus expansion of medical care. A growing healthcare push into communities has given way to the development of ambulatory surgery centers, stand-alone emergency departments and large multi-tenant properties housing physician offices. Some large providers are establishing ambulatory facilities in non-traditional locations, such as shopping centers and vacant big-box retail properties.

Meanwhile, national medical office construction reveals a significant amount of on-campus development, as hospitals respond to the increased demand by replacing aging buildings, adding specialty-based facilities and relocating non-core services to ambulatory settings. In general, many of the most valued features in the medical office sector, such as flexible designs and cost-cutting amenities, are found in these new or newly revamped medical office buildings. Changes in the ways people seek medical care changes the way healthcare developers operate. Developers have to focus on meeting the changing needs and demands of individual clients, hospitals and medical providers.

Investment trends show that continued elevated investment in medical office properties by both private and institutional buyers has helped offset the impact of rising borrowing costs on values. Investors know that healthcare providers need to innovate in order to improve efficiency and profitability in the face of rising costs.

In the Chicago metro area transaction activity of medical office assets rose 11 percent year over year as the average sales price jumped 16% to $222 per square foot. Medical office assets remain the focus of many investors, and while a majority of the offer cap rates occur in the mid-7 to mid-8 percent range, high quality assets - including new construction, those with long lease terms, and properties occupied by strong medical practices or credit rated health systems - can venture into the 6 percent cap rate range and subsequently raise the price per square foot to over $300.

Medical office vacancy slipped below 10 percent in 2013 for the first time in five years, and conditions should tighten further in the remainder of 2014. Asking rents for medical office space were up 1% overall from a year earlier. However, aging properties, particularly those with small floor plates and outdated digital infrastructure, continue to be at a disadvantage. Overall, leasing trends reflect a penchant for modern office buildings.

Increasing medical insurance coverage and patient care, coupled with the realities of a growing aging population means that those who can adapt to the changing realities may stand to benefit. High-quality medical office buildings and patient-centric outpatient services in primary metros, particularly those affiliated with top health systems, will lead the way for medical office property sales and command the most favorable financing terms both in the Midwest and throughout the country.