5 THINGS TO KNOW WHEN INVESTING IN A MEDICAL OFFICE BUILDING | ALLIANCE

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The COVID-19 pandemic has brought a heightened awareness of the importance of America's healthcare system. In turn, many investors are paying closer attention to medical office real estate investments. Medical office, once perceived by some as a niche submarket, is now at the forefront as major healthcare providers extend their reach into the communities they serve.

Yet, a medical office is indeed a unique product type. The size, function, fit-out, mechanical systems, and other aspects of the building are often quite different than traditional office buildings. This article looks at the top things to know when investing in a medical office building.

ARE MEDICAL OFFICE BUILDINGS A GOOD INVESTMENT?

There are many reasons why medical office buildings are a good investment, especially today. As the COVID-19 pandemic has proven, medical office buildings are essentially recession-proof.

This is because they serve a fundamental need: space for doctors and other healthcare providers to provide essential care to their patients. Someone in need of healthcare continues to need that healthcare, regardless of where we are in any market cycle.

Moreover, most providers receive significant reimbursements from insurance, including Medicare and Medicaid, which continue to make payments (typically with annual increases) on behalf of their insured even when the economy struggles.

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This helps to keep healthcare providers' revenues consistent and strong, resulting in prolonged demand for medical office space. In other words, medical office buildings are not as subject to market fluctuations the way other real estate product types tend to be.

In addition, medical office tenants tend to sign long-term leases. Most providers become engrained in their communities, and switching locations can prove difficult–from a technical perspective (moving medical office equipment is challenging) and from a patient perspective (moving can be disruptive for tenants). Investors, therefore, benefit from the predictability and stability of these reliable, long-term tenants.

Construction of new medical office space has also lagged other product types. This has curbed competition and resulted in occupancy rates that have hovered around 90 percent or more over the past decade.

Finally, the outlook for medical offices is strong, in large part because of America's aging population. As the number of people aged 65 and overgrows, there will be increased demand for healthcare services and heightened demand for additional medical office space.

Alliance is a Chicago-based investment firm specializing in net-leased commercial real estate in the United States. Our medical properties range in value from $1M to $25M. Learn more.

5 THINGS TO KNOW WHEN INVESTING IN MEDICAL OFFICE

A medical office is decidedly different from a traditional office, and it is also different from what people consider to be "hospitals." While it is not uncommon for medical offices and hospitals to co-exist, these are two distinct product types that require different infrastructure, capital costs, and sources of financing.

One key difference between medical offices and hospitals is that medical office buildings are usually limited to outpatient care. They do not have emergency rooms and do not treat patients overnight. Physicians providing care may offer day surgeries and other routine procedures, but the level of care needed post-op is generally minimal, and patients are released the same day.

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Here are five other things to know when investing in a medical office.

HOSPITAL AFFILIATIONS DRIVE ASSET VALUE

As noted above, hospitals and medical office buildings are two different types of facilities. That said, a growing number of hospitals are opening satellite locations where physicians can treat patients in a non-hospital setting. Like diagnostic screenings and imaging, many services can be provided remotely at satellite medical office buildings (and often at a lower cost versus a hospital setting).

Whether a medical office building is affiliated with a hospital or not is critically important, as hospital affiliation is a strong indicator of MOB asset value. The rationale is that hospital-affiliated MOB properties tend to provide greater tenant stability and higher credit ratings because the hospital – not an individual physician or practice – serves as the lessee. In turn, hospital-affiliated MOB properties tend to attract attention from institutional investors looking to add low-risk deals to their portfolios.

The balance of MOB facilities is otherwise disaggregated and represents a lower-cost opportunity for investors looking to buy medical office space. Medical office buildings located near but not affiliated with hospitals are particularly attractive. This is because MOB properties within 250 feet of a hospital tend to provide the greatest rent premiums, in large part because reimbursement by the Centers for Medicare & Medicaid Services is 40% greater for these properties compared to off-campus healthcare practices.

DRIVERS OF MOB DEMAND

While there is broad-based demand for medical office facilities nationwide, MOB investors should understand some specific drivers of demand.

The first consideration is around healthcare reform, following the Patient Protection and Affordable Care Act (i.e., "Obamacare") in 2010. This legislation resulted in 32 million more Americans being covered by healthcare insurance. As the newly insured began to seek out medical care, demand for medical office space skyrocketed.

Another major factor to consider is location. As the old real estate adage goes, "location, location, location" – and medical office space is no different.

Location is perhaps the most important factor for investors to consider when purchasing or building a new medical office facility. Investors will want to pay close attention to demographics: What is the profile of area residents? What is the population density?

What is the average median age and income of those residents? How many people are privately insured vs. on Medicare or Medicaid? Locating in a densely populated area with a high concentration of privately insured people will appeal to physicians and other healthcare providers, as private insurers typically have the highest reimbursement rates, which helps to bolster a physician's bottom line.

Assuming there is sufficient demand from residents, the physical location of a MOB is of next consideration. A well-located property – i.e., easily accessible from major roadways, has plentiful parking, is convenient to other neighborhood amenities – will be more desirable than a medical office building that is tucked further afield. Two medical office buildings with the same amenities providing the same level of care will perform drastically differently if one is perceived as a more convenient option for patients. These well-located properties will also attract better tenants willing to pay a premium to be in those locations.

SPACE UTILIZATION

Medical office investors need to understand how building space will be utilized. For example, some facilities are sized to accommodate a single tenant. In this case, that tenant may request a specific fit-out for their business needs (which comes at a cost but can result in higher rent payments and longer-term leases). Other spaces are more appropriate for subdivision and lease to multiple physicians or healthcare providers.

When evaluating a MOB property, investors should consider how many healthcare providers a building can hold, whether there is adequate space for modern-day imaging equipment, whether there will be any lab facilities on-site (or the ability to accommodate them in the future), the size of the patient waiting area(s), and how many parking spaces are available.

This last point is especially important, as medical office buildings need a higher-than-average parking ratio than traditional office or even retail properties. There is usually greater demand for handicapped-accessible parking, which must be located within a specific distance to the entrance. Depending on the types of services that building will provide, there may also need space for an ambulance or other EMS drop-offs.

As investors consider how a space will be utilized, they should also look at its existing infrastructure. Depending on the anticipated tenant mix, there could be more or less demand for high-tech equipment.

As technology advances and healthcare providers become more reliant on it, medical office buildings' power and utility design will need to change. Utility costs will rise, creating demand for "greener" medical facilities with more efficient HVAC systems and sustainable features like geothermal and solar that can help offset the utility costs incurred by providers.

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MONETIZATION OF HEALTHCARE PROPERTIES

Hospitals are under pressure to reduce costs, and one of the primary ways they can do so is by shifting care to outpatient MOB facilities.


Another way to cut costs on their balance sheets is by monetizing their existing real estate assets. Many hospitalize own extensive real estate, yet they cannot manage these properties effectively. Many facilities are in terrific locations but are facing significant capital expenditures. As such, major healthcare providers are starting to re-evaluate their holdings to determine which properties could be disposed of.

It's a win-win opportunity for healthcare providers and MOB investors.

Healthcare providers can rebalance their balance sheets, lease back the properties they sell (if need be), and avoid the costs associated with capital improvements at these facilities. Moreover, healthcare providers can then refocus on their core mission, generally to provide high-quality patient care (not the management of high-quality real estate).

Meanwhile, MOB investors can purchase these well-located properties and optimize them before releasing them to hospitals or other physician-owned practices. MOB investors are understandably much better suited to managing any necessary facility upgrades and property stabilization compared to healthcare providers.

REGULATORY APPROVALS

Depending on how a medical office building will be utilized (i.e., the services and types of care its tenants provide), there may be several regulatory hurdles for a landlord to overcome.

There are two sets of approvals to consider: (1) local permitting approvals; and (2) healthcare approvals.

One of the reasons the construction of new MOB facilities has lagged other product types is that these facilities can be difficult to permit. The same is true for any major capital construction project: replacement, reorganization, renovation, or expansion.

A MOB investor will have to navigate the local zoning process, which looks at a range of things like whether the building type is consistent with current zoning, whether any variances are needed, whether the property is encroaching on neighbors, whether there is sufficient parking, etc. The municipality will also generally ask the owner to look at impacts to wetlands, wildlife, traffic, water and sewer infrastructure, and more.

Facilities that intend to operate with extended hours (i.e., beyond normal 9-to-5 hours) that expect to have overnight stays or anticipate having significant ambulatory drop-offs (especially from local fire departments) may experience resistance from the community. Hiring a local zoning attorney is essential for any investor looking to understand a new MOB construction project or one that will otherwise require extensive permits ahead of leasing.

Once the facility is complete, the space will then undergo a series of inspections. Individual tenants may be required to obtain certain licenses before they can begin seeing patients.

State-level public healthcare departments often oversee the second set of regulatory approvals. Many states require MOB facilities to go through a "determination of need" (DON) or "certificate of need" (CON) process – especially if the facility will be affiliated with a hospital.

This is because most state health departments are tasked with reinvesting healthcare costs, and an expansion of the real healthcare state deemed unnecessary could cause healthcare costs to spiral. The DON/CON process is intended to provide more coordinated planning of new services and construction and, in turn, can impact the size and scope of individual MOB projects.

This regulatory process can be highly cumbersome and, depending on the state, can take anywhere from six months to a year (or more). The DON/CON process carries additional costs, including both time and money, and investors should carefully consider before undertaking any major new endeavor.

FINAL THOUGHTS

There are many good reasons for investors to consider adding medical office buildings to their portfolios. That said, a medical office is a unique niche that has an unusual risk/reward profile compared to more traditional commercial real estate product types. Any investor considering a medical office will want to first understand the quirks associated with medical office buildings. Learning about the sector is the best way for investors to mitigate risk and manage expectations ahead of investing.

All of that said, the outlook for medical offices is so strong – especially given America's aging population, the decentralization of healthcare systems, and growth of specialty care – that it cannot (and should not) be overlooked by investors anymore. Although a small segment of the larger commercial real estate market, the medical office is going to become more prominent in the years to come. Those who invest now will have a jumpstart ahead of their peers.

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