Healthcare Real Estate Developers Get Creative

A few years ago, an older, concrete-tilt building that sat vacant in Torrance, CA, went on the market. Multifamily and hotel developers descended with bids, but ultimately the property was won by Meridian—the only healthcare developer at the table.

Meridian purchased the property and went on to turn the tired building into beautiful multi-tenant medical office building, according to CEO John Pollock. “The updated building now conveys a contemporary image with easy to navigate surface parking and updated interiors that provide an excellent patient experience,” he says. The building is now anchored by an outpatient imaging user.

Now Meridian is working on a deal in Orange County, CA, to convert a liberal arts college with ample parking into a healthcare facility. “Repurposing existing buildings allows Meridian to open opportunities in tight urban locations where land is scarce,” Pollock explains. “It also allows us to meet the user’s requirements more quickly and is often less expensive.”

So goes Meridian’s market strategy for healthcare real estate: Bring more quality medical office properties to the market by repurposing underutilized buildings to fit the needs of healthcare occupiers.

In a larger sense, however, the vacant building in Torrance and the liberal arts college in Orange County are emblematic of what has happened in the healthcare industry this past year. Namely, demand has remained high for product but opportunities for deals has dropped. Companies such as Meridian have had to become increasingly creative.

For a variety of reasons—Pollock points to a decreasing availability of space, land, contractors, qualified craftsmen and raw materials—investment volumes are down this year. According to research from Transwestern, $4.7 billion in healthcare has traded hands nationally through the midyear 2019. While significant, these numbers trail behind the statistics for both 2017 and 2018.

There have also been fewer portfolio deals this year, another factor contributing to the below-average sales volume. “We have only seen one major portfolio sale this year, but it was a big one,” says Eric Johnson, executive managing director of the national healthcare advisory services group at Transwestern. “Welltower purchased a 55-building MOB portfolio scattered in 16 states from CNL, worth $1.25 billion. That is the second largest medical office portfolio ever sold.”

“If I were to characterize 2019, it has been low on quantity but high on quality,” Johnson adds.

None of this, however, has scaled back demand for the asset class.

Healthcare’s Many Demand Drivers

The healthcare market is a beacon for investors looking for yield and opportunities to place capital. Not only does the healthcare market boast strong fundamentals and favorable long-term demographic trends, but the asset class has also shown a keen ability to withstand a recession, making it a popular late-cycle play. This amalgamation of drivers has resulted in increasing investment demand for healthcare opportunities across the country.

“There is a lot to love about healthcare real estate. Demographics, complexity, cost, changing technology and the amount of spending the US devotes to healthcare are all reasons to be optimistic about this sector,” says Pollock. “These factors combine to make a segment of real estate that is far more recession-resistant than others, as healthcare is always needed despite economic trends.”

In particular, the aging baby boomer population has been driving investor interest for several years. The demographic is reaching retirement and an age where they have a higher utilization of healthcare, Jon Boley, SVP at HSA Commercial, explains. “Baby boomers are an active group that has a more procedure-driven utilization of healthcare, and as they get older into a high acuity, they have greater uses of inpatient services and long-term care.”

In fact, the demand for quality low-cost healthcare is growing across most demographic groups. Millennials, for example, want care that is convenient, accessible and on their schedule, says Pollock. “Since millennials are set to overtake boomers in terms of total number, healthcare systems are adapting their delivery models to focus on the patient experience. Ironically, there are a lot of similarities to the needs of these two cohorts and it isn’t their respective ages.” He says the common thread is the need for convenient and accessible care as health systems are having to implement a more distributed network of care “and that often means new or renovated physical space.”

More recently, the sector’s resiliency to economic decline has been attracting investors. “Healthcare has withstood recessions better than other asset classes,” says Boley. “In the 2008 recession, we found that our portfolio continued to perform. Even in a downturn, healthcare services are required and needed, and doctors will continue to see patients. It is an asset class that has withstood recessions. As a result, this late in the cycle, we see an increase in capital in the space.”

Developers Shift Strategies

Healthcare providers have responded to the twin pressures of increased demand and limited supply by shifting their strategies. It has become clear, for instance, that it is easier and more cost effective to service patients from outpatient facilities near population centers. As a result, healthcare developers are absorbing retail properties and hospital-adjacent medical offices, to provide outpatient care for this group.

“The push from inpatient services to outpatient services is driven by technology and lower costs,” Boley says. Noting that outpatient hospitals are presenting interesting opportunities for real estate investors, he particularly points to an outpatient, on-campus facility for Silver Cross Hospital that HSA is currently developing. “The big opportunity now is health system, physician-driven build-to-suit properties,” says Boley. “The Silver Cross property is in an outpatient area of the hospital campus. While there is an emergency room on the campus, there was also a need for a place to appropriately direct patients coming into the emergency rooms but have lower acuity problems, like a fever.”

Healthcare developers are also differentiating themselves by their relationships with operators. Operators are key to an investment’s success, as healthcare assets are far more management intensive than properties in other sectors. “The services provided in the building drive the value, and the building needs to serve the patient and the provider,” Boley says. “Having those relationships with the provider is key.”

Who’s Investing?

Unsurprisingly given the case for healthcare real estate, new investors are entering the space, despite the current issues with supply. REITs have been, and remain, active players in the space, but Johnson is also seeing new partnerships and more foreign capital transacting in healthcare assets. “There is a deep pool of buyers now and it is only getting stronger because of where interest rates are,” he says. “There are more new partnerships, foreign capital and new private equity groups that have not traditionally been in healthcare, that are coming into the space.”

Many of these investors are focusing on core products, with outpatient hospital sponsored deals being the most coveted. For newer entrants into the space, Johnson recommends focusing on secondary markets with recent growth, where there is more risk and less competition. Right now these new players are looking at on-campus properties in major metro markets. “It is hard to win those deals,” he says. “When you are competing against other firms that have a lot of relationships, you have to take a little more risk to get into the space.”

That said, there is no question that the sector is enjoying the largest pool of buyers it has ever had, Johnson continues. “The problem is that when you have a year like 2019 when the volume is down, it is hard to place that money. So, we want to get the volume back up so that we don’t lose some of these folks.”

Johnson is hopeful that investment volumes this year will pick up following the recent turnaround in the Fed’s policy and the subsequent decrease in interest rates. Cap rates for healthcare real estate have averaged 6.4% nationally across the last 12 months, and he expects those numbers to hold through 2020, with the potential for slight cap rate compression if interest rates continue to trend down. Pollock agrees that cap rates and pricing are likely to hold in the next year. “Investors are looking to rebalance their portfolios with the intent to mitigate risk in the event of any economic headwinds, which will keep pricing high and cap rates steady,” he says. “It feels like we are in a prolonged state of sameness. I expect volumes and cap rates to remain relatively unchanged over the next twelve months.”

The Impact of Limited Supply

Johnson’s biggest concern in the year ahead is the lack of supply. “There is so much pent up demand for healthcare, and I think the capital is going to continue to be there,” he says. “The challenge is going to be finding good quality product to place the capital. I hope that changes. We are at good volumes now, but we have had some really banner years the last few years. We are going to be close to those numbers, but we will trail them a little bit and we have more capital. So, it feels a lot more constrained.”

Boley is also concerned about the dearth of opportunities in the short term; a trend that could put pressure on pricing. “Everyone is trying to guess when the cycle is going to shift,” he says. “I think that we are going to see aggressive pricing for healthcare assets as people are looking for credit or stable properties at this point in the cycle. There is still going to be a shortage of product because there is not that much out there.”

For developers like HSA and Meridian, the lack of supply is creating more opportunity for new development, and that is where they are both focusing. “The push to outpatient is real,” says Boley. “Cost pressures will continue on hospital systems because their capital is limited, and the cost-effective way to provide those serves is on an outpatient basis. I think for that reason there will continue to be opportunities for development of outpatient and off-campus facilities. That is where the real opportunity is.” Hospitals are currently the most dominant developer of new product, but Boley sees that changing over the next few years.

Meridian has a robust pipeline, with more than one million square feet in its development or redevelopment cycle, but it is still actively looking for investment opportunities as well, with a particular interest in value-add assets. “We are aggressively looking for more acquisition opportunities throughout California, the Pacific Northwest and the Southwest,” says Pollock. “We really have an appetite for land and buildings where we can bring our expertise to bear and create value.”

That same appetite will keep healthcare investment and development active through 2020 and beyond—just as long as investors can find the right opportunities.