SAN DIEGO—Very little could derail climbing medical-office building prices, other than the threat of rising interest rates, Jones Lang LaSalle's VP Chris Ross and managing director Paul Braun tell GlobeSt.com exclusively. The firm's San Diego healthcare practice group recently released its Q4 2014 medical-office report, which revealed:

• Medical-office-building vacancy in San Diego has fallen below 10% to 9.7%.
• Rents are going up; the high end of rental rates is now $4 triple net, and the average asking rate for medical-office building space is up 2.7% from 12 months ago to $2.54 per square foot.
• Medical practices are forging new partnerships and strategic relationships, consolidating into larger and more-efficient space. This often means moving out of B- and C space and into A and B+ space. Class-A vacancy has been cut in half over the last two years, down to 6.6% today.
• Five of the nine submarkets in San Diego have single-digit medical-office building vacancy; the others will follow within the next 12 months.
• The North County coastal submarket currently supports the highest direct asking rental rates for medical-office-building space.
• Pent-up and increasing demand from buyers will create healthy MOB sales activity in 2015.
• Two new hospitals are in the pipeline for the San Diego market: Jacobs Medical Center, a new 10-story, $939-million hospital on UCSD's La Jolla campus, scheduled to open July 2016; and a new Kaiser Permanente $900-million, 450-bed hospital campus on Ruffin Rd. in Kearny Mesa, scheduled to open in 2017.

After the report's release, we spoke with Ross and Braun about San Diego's hot medical-office market, the investment sector for this market and what could potential hamper it.

GlobeSt.com: What do you feel is most responsible for the medical-office vacancy dipping below 10% in San Diego?

Ross: It's a combination of things that people have been talking about for several years now: healthcare reform and the change that that's creating and consolidation and the change that that's creating. Hospitals need to adjust, and they're pushing services off campus. Part of this is due to healthcare reform and technology allowing hospitals to push services out of the acute-care setting and into medical-office buildings. There's demand growth there, and as the economy has recovered, medical and surgery groups have gotten more bullish on expansion. It is a supply-constrained market. Everybody talks about all the construction in healthcare, but most of it is on hospital campuses; there's very little on outpatient MOBs. There's a demand for space, and absorption is taking place, there's next to no construction. That's going to be the challenge for years to come: there's very little developable land, and then you factor in zoning, parking restraints and other restrictions.

Braun: In addition to healthcare reform, a lot of health systems are still strategizing how they're going to care for the big Baby-Boomer wave. There's an onslaught of real increase in demand because of that. Conversion of retail space to medical office is not happening in San Diego. The vacancy factor for retail product here is very small, and a lot of retail product in our county is well located and has a high value. They don't see the discrepancy in rental rates where they could go to cheaper product. I recently saw at a conference that Nashville has seen several retail centers converted over by healthcare systems to deliver care, but because the vacancy factor is so small here, it hasn't really happened yet in San Diego.

GlobeSt.com: What could potentially derail climbing valuations for medical-office properties here?

Ross: The one thing everybody talks about as far as the unknown is interest rates rising, and when they do, so will cap rates. But there's so much continued pressure on these. There's a perfect storm of capital in the medical-office space. A lot of REITs, whether publicly traded or not, are under pressure to deploy capital, so prices get competitively built up, particularly if the core property is on a hospital campus or something leased or master-leased by a health system or hospital-affiliated physician group of some sort. There's so much capital to deploy that cap rates are pushing down, and as you get off-core, there's lots of institutional and private capital chasing office buildings given how well the sector did during the downturn. They are balancing their portfolios with whatever else they own, either buying for the first time or doing a 1031 exchange on an office building and trading into medical office here. There are new buyers, pent-up demand for property, and developers who may have developed a building and only the last couple of years stabilized it and/or it's time to sell and move on. That could slow down, but I don't know that there are many threats. There's no overbuilding, and healthcare continues to grow and evolve.

One potential threat is in areas where there's more developable land, like parts of North County and the 78 corridor, where people got bullish on medical office—especially as the office market started to soften-- and converted other uses to medical office but didn't understand the market that well. It's not an area of focus for most. It may not be an optimal medical-office site, and if you get a lot of people jumping in at the same time, the market softens and you have overbuilding. It's a good thing this is not happening.

Braun: If you look at the last three downturns in the market that have affected a lot of the commercial-office product, these properties suffer by devaluation and lack of activity; whereas healthcare real estate isn't recession proof, but more recession resistant. Maybe less activity is what happens, but values tend not to drop nearly as dramatically as we see in other markets. Investors trying to place capital in other markets will go to medical office because it is conservative and consistent.

GlobeSt.com: What else should our readers know about the San Diego healthcare real estate market?

Braun: Class-A and –B product is seeing most of the activity as healthcare systems and provider groups are looking for better-located visible product. We're seeing a migration of users going from class-B product to class-A product.

Ross: As healthcare reform is now kicking into full steam here, hospitals and health systems are not going to be reimbursed for quality as opposed to just service. Part of patient-satisfaction scores are tied to patient experience, not just actual healthcare: they will consider getting to the building, finding the property, parking, finding the physician, etc. Hospitals are paying more attention to facilities in that regard and are considering if it's well located, if there's good parking and what the healing environment is like. If it's an antiquated space without much natural light and a cramped waiting room, the patient-satisfaction scores are not going to be good, and that will affect reimbursement.

Braun: Some health systems are getting out in front of that and getting more proactive about their space. This is a continuing trend going forward.