Medical Office And Life Sciences: Two Sides Of An Investment Coin

In commercial real estate, property types typically are conceptually far removed from each other. Industrial has nothing to do with multifamily, which isn’t office. Mixed use takes dissimilar things that happen to work together.

But things begin to look a little different when the discussion turns to life sciences and medical office. They are like the flip sides of a coin — research and development on one side, clinical application on the other. But while there are complements, investors often tend to embrace one or the other. Here’s why, and how each of the categories is doing at the moment.

TWO PLACES IN THE SAME NEIGHBORHOOD

There isn’t a tug-of-war between life science and medical office when it comes to investors.

“These two asset classes in commercial real estate that are often confused with one another,” says Avison Young Principal and Managing Director Nick Banks. “They have some similarities, but they’re quite different.”

For example, they are both ultimately about medical care, although at different locations in the process. Life science is R&D and product development. Medical office, tied in with hospitals, is essentially the retail side, providing care close to where people live.

“Same church, different pew,” says Joel Berger of Bradford Allen. “It’s the same universe as medical office but they’re two fundamentally different businesses.”

Those fundamental differences express themselves through specifics of ideal locations, property and facilities requirements, HVAC needs, equipment, staffing, tenant sizes, revenue sources, longevity, support systems, and even parking.

While some investors are involved in both, they usually specialize in one or the other. “Specialization is something I think that is increasing in every part of the economy,” Banks says. “Capital to some extent is agnostic and seeking yield,” but it is hard to be expert in all areas.

There is competition, but it tends to be perceived differently from other investment choices. “If your bank is offering 5% on your money for a money market account, that is a very safe bet right now relative to other investment choices,” Banks says. “Investors are weighing that risk versus reward dynamic. These types of investments are competing for investment dollars that in a more normalized market might be available for other types of investments.”

But it’s unlikely according to multiple sources that investors are giving up either medical office or life science properties for the other.

MEDICAL OFFICE DETAILS

There are multiple major differences between the product types. The most basic is in the business dynamics of the different types of tenants.

“Medical office always had a sort of retail component to it,” says Berger. “You’re seeing the real estate finally reflect that it’s a retail business. It used to be built for utility, not comfort. Now it’s being done for the patient experience.”

And it’s a “win-win-win,” as he puts it. “Neighborhoods like it because it brings traffic. It’s an industry niche that has a good reputation. It has the feeling of something that benefits the community.” Also, because supply has never outpaced demand, you’re seeing rent growth, he adds. Because the practices don’t leave, landlords can increase the rents over time. The tenants are either large entities with significant revenues or multiple smaller practices that typically have good credit.

As with other types of retail, convenience matters. “A lot of people looking to buy medical buildings want it within a mile or two near a hospital. A mile or less is ideal,” says Christie Grays Chambers, a vice president at Blanca Commercial Real Estate in South Florida. Additionally, it also needs good placement near highly residential communities, with plenty of people passing by. “If it’s situated in a place not high in residential, it’s not going to be full. If it’s on your way home or a little bit out of the way, that’s your preferred location.”

Part of the retail aspect is what medical offices need to provide to attract and keep patients, including parking and easy physical access, Berger says. “In the Midwest, there’s significantly more medical office than life sciences. For every one life sciences building, there are 10 medical office buildings.” In his area, build-outs are about $100 to $150 per square foot.

He says there is also a competitive aspect, as with retail. “Medical offices are competing with each other for patients, like Home Depot and Lowe’s compete for customers.” But not entirely like retail. “It’s become one of the only recession-proof segments of commercial real estate. Covid emboldened it.”

There are still some types of doctors who work in solo practices — dermatologists or plastic surgeons, for example. But most are either under the umbrella of a larger physicians’ practice group or of a hospital or healthcare provider, in large part because of the negotiation advantage when dealing with insurance companies. Medical office space will house practices, but also clinics, labs, imaging centers, and other specialized practices that can be performed more economically than in a hospital.

That dovetails into the location strategies of many physician groups. Existing office leasing is typically long-term in nature. Once a practice has a steady clientele, the practitioners don’t want to upset the dynamic by moving. However, they will expand to additional locations, or newer doctors might decide to set up shop in an area with little competition and grow their business.

“Doctors are going to where the people are and the suburbs are pretty popular, so a lot of these doctor groups are moving out to the suburbs,” says Andrew Brod, managing director in Houston for Whitebox Real Estate, a tenant representation firm. That is true even as many existing practices prefer to stay close to the Texas Medical Center, with a strong medical infrastructure and ready source of new practitioners graduating every year.

The medical infrastructure — imaging facilities, labs, hospitals, specialized practices, and so on — is important. So are costs. “Your class-A buildings are typically going to be $45 to $50” per square foot annually, Brod says. “Typically, out in the Woodlands [28 miles north of Houston], I’m going to guess they’re maybe $35 per square foot for a class-A building.” That’s a 20% to 30% savings for a major expense.

HOW LIFE SCIENCE RUNS

Life science real estate is similar in having to support specific needs of tenants that are in fields related to medical studies and care. But after that, things can be quite different.

As medical offices typically need proximity to hospitals, life science seeks common ground. “A critical foundation of the ecosystem [is] a major university with a life science focus,” says Avison Young’s Banks, who is based in Gainesville, Florida. For example, the University of Florida there has a major bioscience incubator that he says generates hundreds of patents a year. That flood of research helps power new inventions and companies, as is true in principle at other research universities.

That work is a time and money saver, with grants and university support covering basic research until it shows sufficient promise. Investors in life science companies can see some degree of positive results, even if not yet commercialized, that can jump-start a new business. Professors can bring talented colleagues and PhD-track students to the venture, attracting investors.

But, again, for the pipeline to work, life science firms must be close enough to research universities, which means that CRE developers and investors looking to work in life sciences have limitations as to where they can invest. This gets trickier than it might seem.

Not only are there geographic restrictions, but the building requirements are exacting and specific to a firm. In general, “anywhere from 20 to 60% lab and then the rest would be office,” says Brod. HVAC gets complex with the need to scrub outgoing air exchanges which might carry biological hazards. While offices might be generic, lab needs aren’t. “Every building is different; every floor is different.”

“I would say the majority of them are single-tenant,” Banks says. “In some of the major clients, there is no choice to have a variety of different tenants in one building,” which becomes a challenge.

“Two or three years ago, there was a virtual feeding frenzy for space to the point where I had clients trying to do built-to-suit leases, where you sign a lease with a tenant and then build a specific building for the tenant,” says Cozen O’Connor member Adam Silverman. “That was problematic because the time was too long.” Tenants needed to get in right away and couldn’t wait.

So, planning life science properties is generally much harder than for medical office. The latter is usually just that, office space with some additional considerations in plumbing and HVAC, unless there will be heavy specialty equipment like imaging systems that might require reinforced floors and possibly additional height.

LIFE SCIENCE INVESTMENT FRONT

From what owners, operators, and investors are currently saying, life sciences has some challenges. Cozen O’Connor’s Silverman, who mentioned the overly long time frames for readying buildings, said that some of his clients started doing spec construction.

“In the interim, the economy has turned,” he says. “There was a lot of money in life sciences. It’s a very tight market now. I think everyone used it as a pause. Now they’re having trouble leasing up the buildings they have. But I think everybody expects that in the next six months, 12 months, 18 months, this will turn again. The demand is still there, the science is still there. It will just take time for the lending to loosen up and things get going again and people acclimate to the new economic reality.”

Scott Metzner, founder and president of developer and owner firm Janus Property Company in New York City, has been in CRE for 35 years. “How do I think the New York life sciences market is doing?” he says. “There has been incremental growth and there has been a continuing sort of connection between the various stakeholders, government and private and university, that I think is going to be really helpful and necessary for New York City to be a leader in the field.”

But that’s the long-term. Right now, things are tight. “I think it’s been so hot, so long that people were taking for granted that that sort of pace and demand would maybe go on forever,” Metzner says. “Nationally, the market has taken a step back.”

There are capital constraints on the private equity and venture fund side, says Banks, which has “largely hit the pause button.” The firms depend on limited partners to provide the capital for investment. But the investors typically are looking for a return and are not tied to a given sector.

Investors in funds are looking for return, not necessarily from a given sector. “The companies that are affected by that the most are the emerging companies.” Maybe novel drug therapy or a device going through the FDA approval process. “They’re having trouble fueling the equity capital they need.”

There are several reasons. One is the availability of alternative investment choices. “There’s no question there’s less liquidity in the life sciences industry,” says Metzner. “There’s less liquidity in any industry right now, except maybe AI. If a person can get 5% in a treasury, it makes it tough to take a risk in a startup.” (At the time of writing, the 10-year yield was almost 4.6% and the 6-month was 5.53%.)

And then there is investor concern with the sector itself and whether it can continue providing the returns it had. With the government having largely treated Covid-19 as something over, there isn’t the urgency to pump public funds into medical solutions. The potential upside has fallen. The S&P 500 Life Sciences Tools & Services Industry Index hit an all-time high on January 1, 2022. It was down 27.9% between then and October 1, 2023.

“All that said, the good news is the market is still very tight overall,” as Banks notes, with overall occupancy for lab space is about 98%. “Companies are making do, developers and landlords are making do. When there is a need for space, often ground-up development with a new facility is the only answer. I’m hopeful that because when the demand has been relatively strong all along, when capital eases up, there’s going to be plenty of demand for new space.”

But expect that to be pricey. Land prices in metro areas and construction costs will be high. “It’s just gotten very expensive,” Brod says.

THE MEDICAL OFFICE OUTLOOK

Medical office is in a completely different state. According to the Bureau of Labor Statistics, the job outlook for physicians and surgeons between 2022 and 2032 will be average, meaning 3% growth. They all need places to be.

“You still are seeing traditional medical office buildings being built,” says Brod. There is more flexibility because medical practices are ultimately needed everywhere, there are far fewer constraints on construction than with life science properties, and tenant improvement is less expensive for medical office than for life science. As Berger says, demand for medical office space has never exceeded supply and the construction costs are about half of those for life science properties.

Across the country, there is also probably far more medical office than life science, meaning a greater spread of opportunity. Berger estimates that in the Midwest, medical office outnumber life science buildings by 10 to one. “The world of tenants that need a life sciences building is much smaller than with MOB,” he says, “and traffic is about one-fifth that for MOB.”

Also, existing office buildings can be turned into medical office with relative ease. “You’re seeing new development, new adaptive reuse,” Berger says. “Buildings that maybe were 65% or 70% office with a handful of doctors, you’re seeing them go all doctors. I don’t think there’s ever been a point in commercial real estate where people said there’s a lot of empty medical space.”

“As far as investing, you’re really seeing both these spaces attracting dollars, although like for medical office, on the investment side, depending on which group you look at, it was down last year and first half this year was down 50% to 60%,” says John Wilson, president of HSA PrimeCare. “There’s still strong interest in this space. It’s more letting the economic climate calm.” With single-digit vacancy rates and strong fundamentals like life science but backed by healthcare spending rather than venture funding, it’s still a strong bet for today. And for the future, because with an aging population, there will be plenty of needs for doctors of all sorts, and the medical offices they lease.