Medical Office Buildings’ Big Moment

Medical office buildings are having a moment, with investors flocking to the sector as a more stable alternative to suburban office holdings. Rents are at record highs, deal flow is strong, and demand is outpacing supply amid tight vacancy rates and stable cap rates.

The fundamentals are solid—especially when compared to the office sector as a whole. According to Colliers, average rents for medical office buildings ticked up to $22.61 per square foot in 2021, a year-over-year increase of 1.7% and a new high for the sector. The national vacancy rate fell by 10 basis points to 8.3%—a metric that’s especially positive when viewed against the broader office vacancy rate of 14.8% in 2021—and net absorption across the top 100 markets totaled 19.1 million square feet last year.

“Medical office has been a very attractive asset class to both institutional and retail investors for many years due to the stable tenancy of creditworthy tenants with long-term leases who don’t often move,” says Michael Dettling, principal, Healthcare Real Estate Services at Avi-son Young. “The sector enjoys low vacancy, strong rent rates and steady returns to investors.”

And healthcare spending remains sky-high: in 2021, the Centers for Medicare and Medicaid Services estimated healthcare spending in the US to exceed $4.3 trillion, which amounts to between $12,000 and $13,000 per person. National healthcare spending is predicted to top $6.8 trillion by 2030.

“Historically a lot people view medical office buildings as a recession proof or recession resistant asset class, and that’s largely because the secular drivers are generally things people retain even when the overall economy is under stress,” says Jacob Albers, a research manager in Cushman & Wakefield’s Global Think Tank group. “Healthcare spending is one of the categories consumers tend to cut the least—and we’ve also seen that despite the pressures of COVID, healthcare spending has reached new record highs.”

Investors are taking note: Colliers research shows that total investment in MOBs rose from $11.9 billion in 2020 to $17.4 billion in 2021, a sector record. Average pricing rose to $375 per square foot, while average cap rates fell by 20 basis points to 6.1%. In the third quarter of 2022, investor demand hit its highest trailing four-quarter average on record, thanks largely to an excellent Q4 2021.

The buyer profile is heavily dominated by private investors, which accounted for 67% of sales volume last year, followed by REITs at 24%, hospitals and healthcare systems at 7% and provider/owners at 2%. And private investors and REITs tend to be more willing to pay higher prices for assets, at averages of $383 and $382 per square foot, respectively, versus $324 per square foot paid by hospitals and health sys-tems and $302 per square foot paid by provider/owners, according to Colliers.

Experts say investors are drawn to the sector thanks largely to substantial macroeconomic headwinds—which include an aging boomer population and the overwhelming need to provide most healthcare services in person at a physical site. Medical office buildings typically involve long-term leases, less turnover between leases, higher occupancy and better below-the-line capital expenditure performance—and medical professionals also tend to be among the most creditworthy tenants.

All of this combines to “create a more durable income stream and significantly lower risk profile,” says Brannan Knott, managing director, capital markets at JLL. “The historical performance during turbulent markets has made it the darling of portfolio managers and investors alike, which has been evidenced by all the new capital stepping into the sector.”

Adler says there are usually two types of medical office buildings: those that are adjacent to hospitals, and those that are around popula-tion centers and other retail offerings. Medical office buildings represent about 10% of total office stock, according to Yardi—compare that with life sciences at just 2%—and has rapidly emerged as an investor favorite, and in many cases compares favorably to beleaguered sub-urban office options, in the wake of COVID-19.

“The needs for medical services are broad and they’re driven by the population,” Adler says. “And you can get good data on those needs to help you make strong investment decisions. You can find out where people are and how old they are. You can get data on where the other specialists are in a metro area. It’s just a very stable asset class, and that means while you won’t have the highs, you’re not going to get the lows.”

Gary Chou of Berkeley Capital Advisors in Orange County, Calif., says a class of medical office space has evolved and become “very net lease,” an increasingly important category that’s grown significantly over the last five years. Previously, MBOs were viewed as more man-agement-intensive, whether the offices were located in a strip center or traditional medical office tower.

Chou notes that he and his colleagues at Berkeley Capital have observed an uptick in the type of funds that are focused specifically on the medical office net lease space. Consolidation of the overall healthcare industry has also been a huge driver of the net lease portion of the medical office building market, and has prompted many of Chou’s clients to delve into the space, lured by the enhanced creditworthi-ness of tenants.

“The MOB REITs and institutions that have been out there playing in the space have continued to do well, to consolidate, and to draw in-creased interest for investors,” he says. “These are all clear indications the space has grown and evolved. I’m bullish on the sector, and at the end of the day if you’re comparing medical space versus other real estate types, MOB will do well. There are a lot of other economic tail-winds that will help it continue to grow even if we end up in a recession.”

STILL OFF RECORD GROWTH OF PANDEMIC YEARS

Cushman & Wakefield has observed strong revenue growth for the sector over the past year, with stable occupancy and robust investor inter-est in high-quality assets.

“I think generally MBO has been more robust than other asset classes,” Albers notes. “We’ve seen a lot of investors increasingly diversify the allocation of their portfolios toward more alternative asset types like MBO that dilutes risk over a greater swath of the economy.”

There are also significant M&A opportunities in the space, experts say. Cushman’s Albers says many of the firm’s larger MBO projects are consolidation deals, whether M&A or aggregating multiple portfolios. He says he expects to see more of that activity going forward, as many organizations feel the pinch of inflation and tapering of pandemic reimbursement programs at the state and federal level.

“There’s a lot of incentive to consolidate and build more to scale,” Albers says. “There’s an increasing difficulty for debt sourcing across asset classes—but in the range of things I think MBO will be more robust as compared to more primary asset classes.”

The asset has also emerged as a viable alternative to suburban office holdings, which have suffered as the result of the ongoing shift to remote and hybrid work arrangements.

“We’ve seen a lot of new entrants come into MOB and try to make a splash and place capital and start doing transactions,” Albers says. “But there are a lot more nuances involved with medical office. Depending on what specialties your medical office will have, that could lead to a lot more complexity than a traditional office deal. It does offer an alternative play for investors who are heavily into office space, but there definitely is a learning curve there. You can’t just get into one and assume in a given submarket where you have some stake in subur-ban office to transition without really doing your homework. You have to do the underlying analyses to make those decisions.”

JLL’s Knott expects the underlying performance of the sector should outperform other asset classes as a whole. In the wake of the Fed’s most recent September rate hike, he expects cap rates to continue to expand, “which should create buying opportunities for many to acquire fantastic assets at reasonable cost basis,” he says.

TENANT MIX, INFRASTRUCTURE IS CRITICAL FOR SUCCESS Attracting the right tenant mix is key, according to Adler: “Landlords have to recruit the right specialists to be in the office,” he says. “And they have to be able to tell the specialists the number of patients and other providers in, say, a five-mile radius so that prospective tenants can see there’s room for them because they’re serving an unmet or underserved need.”

The power to harness demographic data is also important. If you’re in a region with a younger population, more pediatricians will be in demand. If you can determine how far people are driving to get to a certain speciality, that can also play a critical role in determining tenant mix.

Then there’s the physical infrastructure: because medical office buildings are typically subject to more stringent regulations and local and state health codes, the physical infrastructure necessary is often quite different than a traditional office.

“You can’t just retrofit it as you would a general office,” Yardi’s Adler says. “The physical piece of it is not easily converted one-to-one. You have to know what you’re doing.”

OVERBUILDING REMAINS A HEADWIND The US is currently home to about 1.9 billion square feet of medical office space, with 17.6 million square feet under construction, 19.7 mil-lion square feet planned, and another 65.6 million square feet in the prospective phase, according to Yardi Matrix data.

“The major issue for medical office is making sure supply is managed,” Adler says. “The sector, because of its complexity, does a much better job of managing supply because there’s more thought put into it. As opposed to an asset class like self-storage, where you don’t need to know who your customers really are, with medical office buildings you really need to know who your tenants are going to be. It’s definitely a more thoughtful sector and requires much more forward thinking and more planning.”

Cushman’s Albers agrees, noting that the sector has seen a record level of construction starts over the last 12 months in terms of square footage.

“It will be interesting to see how sustainable that is going forward,” he says.

BID-ASK GAP IS DEEPENING Knott says investors have continued a flight to quality healthcare real estate assets amid the Fed’s series of aggressive rate hikes over the last year. Lending in the space tends to be dominated by balance sheet commercial bank lenders, which account for more than 90% of new loans for medical office buildings and hospitals—unlike other sectors that are more dependent on securitized debt and life insurance com-pany financing. But Knott says lenders have been “continuously active” in underwriting new loans, and calls JLL’s pipeline heading into the new year “frothy” and “as busy as ever.”

“Certainly there are still a number of investors on the sideline, so the frenzy of offers we experienced in the run-up from 2020 through the first half of 2022, has declined,” Knott says. “This has created a buying opportunity for the pure-play investors in the space and for many of the new entrants. Capital is still abundant for continued allocation and deployment into the sector, but it is just some new buckets of capital coming to the table mixed with long-standing healthcare investors.”

Avison Young’s Dettling says that market uncertainties have led to an overall pause in deal flow as a pricing gap between bid and ask emerges between buyers and sellers.

“Buyers are waiting for rates and market certainty to clarify despite significant capital ready to be deployed,” he says. “Buyers will patiently await direction of rates, access to debt and market conditions before sales volume picks up in another twelve months or so. Keep the powder dry.”

Looking ahead, Yardi’s Adler says the sector will continue to be positioned as recession-resistant, thanks largely to the stability it offers. Despite economic conditions, people still get sick and need help—and that means better cash flows for investors. Medical office isn’t subject to the same reimagining of the workplace that the overall office sector is enduring, and while it requires a good bit of diligence on the front end to understand physical building requirements, demographic data and tenant mix, it doesn’t have the capital requirements of other spe-cialty niche sectors like life sciences.

“It’s an interesting niche for people who know what they’re doing, but anyone who thinks it’s free money will get hurt on the execution,” Adler says. “With that said, it’s a great niche and if you’re going to be in the office world that’s a place you’d like to be. Demographics are in its favor, but it takes some skill to match up the need for medical services with the available supply. I don’t think this is for the faint of heart.”