COVER STORY, FEBRUARY 2012

STATE OF THE HEALTHCARE REAL ESTATE INDUSTRY
Nellie Day

Western Real Estate Business asked three experts, whose specialties include healthcare design, leasing, management and development, to weigh in on the medical office building and healthcare real estate industry as our population ages and healthcare reform becomes a hotter topic than ever.

How is the aging boomer population affecting the healthcare real estate industry?

Talbot

By 2030, there will be about 78 million baby boomers — 60 percent of them are predicted to be monitoring one or more chronic conditions. It is estimated that 33 percent will be obese, 25 percent diabetic, 50 percent will have arthritis and the number of knee replacements will multiply by eight. According to the Centers for Disease Control, more than half of all doctor visits are members of this generation. This increase in demand will require more healthcare providers and more medical space to treat those patient visits.

— Trisha A. Talbot, senior vice president, Healthcare Investment Group at GPE Commercial Advisors

How are most healthcare projects getting funded nowadays? Is this process getting easier or harder?

Clark

Generally speaking, funding is not getting any easier, but is being accomplished in a variety of ways. (Nonprofit) Hospitals or systems with strong credit ratings may go to the bond market, when the conditions are attractive. But with a climate that doesn’t always favor this traditional type of funding, these same systems are also taking advantage of the increasing supply of investment capital pursuing healthcare transactions and are using third-party capital for new development projects.

Hospitals or systems with ratings that aren’t as strong increasingly are looking to third-party capital and ownership for new projects. Regardless of the credit rating, speed to market is imperative for new healthcare. Third-party development and financing can be more efficient than funding internally or through tax-exempt alternatives.

— Jason J. Clark, managing director, healthcare solutions, Jones Lang LaSalle Americas, Inc.

What are the biggest trends in healthcare construction and development that you see right now?

Kragelund

Lean strategies and processes are a significant part of the healthcare service industry that is transforming decisions and approaches related management and operations of services and facilities. This trend challenges the planning, design and construction industry to introduce lean thinking and process improvement approaches into facility planning and construction delivery. Owners are looking for collaborative implementation strategies that help them evaluate better solutions that increase efficiencies, improve client/patient experiences, assist in speed of delivery for services, achieve reasonable first-cost certainty and reductions in total life cycle cost of developments, maximizing their value and minimizing risk.

— Joey Kragelund, associate vice president and principal of healthcare design, HGA Architects and Engineers

What are the advantages of leasing over owning healthcare real estate in this economy?

Healthcare providers that purchased buildings or office condominiums in the boom are likely realizing some of the aspects of real estate ownership. These include the costs and management efforts associated with maintenance and a reduction in property value. If they’re dealing with tenants, they must also focus on lease negotiations, renewal negotiations, property management and/or rent reductions for existing or new tenants.

When leasing office space, healthcare providers can focus on their core competency of providing healthcare services. In this tenant market, tenants can take advantage of a variety of leasing incentives. Right now the cost of a mortgage and the cost of a monthly lease are most likely equal in many cases.

— Talbot

Are fully integrated IT infrastructures catching on at many new healthcare campuses/facilities?

We are seeing significant capital expenditures—cumulatively reaching billions of dollars--toward integrated IT infrastructures. The primary focus or mandate is to reduce errors, centralize data for storage and accessibility and produce continued efficiencies. It’s also an invaluable tool for doing research and improving care. With that being said, new federal legislation focused on Accountable Care Models (ACOs) will mandate this type of IT platform for accessing data and quantifying reimbursement payments.

Some healthcare systems started this process last decade, but only 25 percent of hospitals currently use electronic patient records. We will see this number grow exponentially due to the 2009 federal stimulus package incentives and federal mandates for ACO model payments. As of today, only $2.5 billion of the $27 billion stimulus funds has been used. Due to the large capital expenditure need for IT implementation, some hospitals are looking at various cost-saving strategies, including improving how they manage their healthcare real estate overall, as a means to help fund IT initiatives that otherwise may be difficult to fund.

— Clark

Do you think green-building/sustainability is or will become a mainstay in the healthcare RE industry?

Trends and innovation in green building/sustainability/energy efficiency services and technologies will continue to emerge and evolve, having an impact on the design and construction industry as a whole. There are energy efficiency and sustainability strategies that make good, strategic sense in healthcare and for healthcare developments. The first cost of capital projects and infrastructure improvements have a substantial influence in the initial development and decision-making process for healthcare projects. However, with the total life cycle cost of a building or development being many times that of the initial project costs, owners are looking for ways to achieve reductions in the total life cycle costs of management, operations and maintenance for the estimated or expected life of those improvements and investments.

— Kragelund

How is the political climate and upcoming election affecting the level of activity and decision-making powers of healthcare administrators and developers?

Healthcare providers are putting decisions in a holding pattern. While the healthcare reform bill will start being implemented this year, and 32 million additional insured individuals are anticipated by 2014, the upcoming Supreme Court case and decision is also being weighed. Many practices and physicians are looking to go underneath the hospital employment umbrella.

— Talbot

Outpatient centers seem to be the new trend (vs. hospitals). Do you agree? Why or why not?

Following the trend of reduced cost, enhanced delivery of care and speed to market, the delivery of outpatient centers is growing exponentially. We traditionally see a 70:30 ratio of acute to ambulatory/outpatient centers, but I think the inverse will be true in five to 10 years. Healthcare systems can quickly play offense and defense, grabbing market share and branding their names in new territories while giving those communities better access to care. In that quest for the best location and low-cost delivery, some healthcare systems are even looking at distressed commercial real estate buildings and retrofitting for medical use.

— Clark

What are the factors currently influencing a healthcare owner’s planning and development strategies?

Rapid developments in advanced technologies, healthcare service and insurance reforms substantially influence owners’ strategic planning and delivery strategies of their services. Owners are looking for flexible and innovative ways to better deliver service to their clients, patients and the communities they serve by placing services that are not best suited to be in an acute care/hospital environment into appropriate outpatient environments that are closer to the community and more consumer-oriented. They do this in the hopes of achieving better outcomes, maximizing satisfaction and increasing their competitiveness.

— Kragelund

Financing MOBs Michael Sieman Sieman Medical office buildings are considered a specialty use. Since many lenders will not or have not financed MOBs, identifying those experienced with this asset is critical for a successful financing. Whether traditional 10-year debt, fully amortizing structures or even shorter term, higher leverage or higher priced debt that can include limited value creation plays, there is typically a lender attracted to the deal based on the specific underwriting criteria. Even in today’s market, leverage levels up to 75 percent with rates less than 5 percent are available on stabilized assets. Of course, the preference is for more conservative loan to values and shorter amortization schedules, but the point to be realized is there are more financing structures available than your standard vanilla CMBS loans. Many borrowers don’t realize that. While the government has direct effects on the healthcare industry, demographic changes and a growing health-conscious society constantly bombarded with new pharmaceutical therapies (just count how many prescription drug commercials are in the Super Bowl) demonstrate the demand for healthcare is strong and will continue to grow. Consolidation is a continuing trend manifest from government involvement and can quickly change a rent roll. The positive is that a weaker credit is typically replaced by a stronger one on a lease obligation, and tenants in well-located assets either on a hospital campus or in strong satellite areas will expand. These same space considerations however will often see older or functionally obsolete buildings in non-critical, off-campus locations suffer. Sponsorship is key in MOBs — especially for off-campus assets — but not in the same way as in more traditional commercial real estate investments. Here owner-occupied doctor groups or hospitals themselves can still receive favorable underwriting treatment. Their commitment to their investments and their businesses can be more important to the underwriting than a real estate professional who will try to compete for tenants in the general marketplace. Even better is sponsorship that features a commercial real estate professional in a joint venture with the tenants. In this very situation we have delivered quotes up to 75 percent loan to value at 5 percent for a ‘90s vintage off-campus MOB. Lender preference is typically for on-campus MOBs, however underwriting these investments is no simple task. These assets are typically located on land subject to an unsubordinated ground lease. Sometimes they’re located in urban situations, which is what happened with a newly developed LEED-certified building that we just financed. It was part of an unsubordinated air-rights lease for a to-be-built MOB. This requirement is dictated by the fact that the hospital is already subject to underlying bond financing. Lenders have different legal requirements in these situations and others won’t consider the more complex collateral situations at all even if they are active MOB lenders in all other cases. Like other types of real estate, development of new MOB has suffered through the Great Recession. Financing is available for build-to-suit developments, however many times healthcare providers, specifically hospitals, don’t want to be owners of MOBs. One successful development mechanism utilizes a master-lease from hospital or similar strong credit to provide a backstop for the financing. Then the developer and master-tenant can work to sub-lease space to smaller doctor groups under appropriate agreements. The development of an MOB is typically more expensive than a traditional office building when providing the needs for the end-user. Higher rents sometimes require that comps be located outside the subject area, submarket or even market. The resulting high loan per foot can also scare lenders that are willing to consider the underwriting as a whole. Such was the case in a recent financing we completed in California. Even with an on-campus MOB occupied under a long-term lease by the same investment-grade credit hospital contributing the land and a national developer, many lenders had a difficult time reconciling the high loan per foot. This resulted from the use of the building as an ambulatory surgery center. Additionally, comps were not readily available in the immediate subject area. At the end, though, there were still lenders that could get comfortable with the investment. They quoted anywhere from 65 percent to 75 percent loan to value with rates from 5 percent to 6.5 percent. By understanding the nature of MOBs in their various formats and different risk mitigants, many capital providers are able to offer competitive terms to their clients. In doing so, they make strong investments that should perform well into the future. — Michael Sieman, senior vice president, senior director, NorthMarq Capital

Aging Boomer Generation to Exert Major Impact on Healthcare By Donna F. Jarmusz Jarmusz The aging boomer population is exerting a major impact on the healthcare real estate industry. The 65-and-older population will grow 36 percent (about 15 million people) over the next 10 years. And this demographic will increasingly be living with chronic conditions that will put enormous demands on our system. People are living longer. The number of octogenarians is growing at three times the rate of the general population (about six million people). This means Medicare will continue to be the biggest healthcare payer as our elderly form a bigger part of our population. Combine this with the fact that we are adding 32 million people to our healthcare rolls because of reform, that we are increasing dependent coverage to 26 and that Medicaid enrollment has increased to more than 51 million people and it becomes clear the providers have to be poised for a surge of new patients. In terms of financing projects, healthcare is a $1-trillion real estate market — and 90 percent of these assets are privately owned. Most are owned by not-for profit hospitals and by private investors, including physician groups and the for-profit system. Non-profit hospitals, including facilities owned by state and local governments, account for about 80 percent of acute-care hospitals in the U.S., according to the Wall Street Journal. In the case of non-profit hospital owned, the primary source of funding remains tax-exempt bonds, which represent a less-costly way to finance projects. This is particularly true with the Fed funds rate and T-bills at historic lows. The problem is that non-profit hospital revenues grew at an average rate of only 4 percent in 2010, a 20-year low, according to Moody’s. Moreover, the rate of revenue growth is expected to continue dropping. Federal cuts in Medicare and state efforts to save money in Medicaid spending will hurt hospitals’ bottom lines. Medicare represents about 43 percent of hospital revenues, while Medicaid accounts for another 11 percent. With more and more nonprofit hospitals feeling financial pressure, an increasing number are merging with larger outfits or selling themselves to for-profit companies, the Journal reports. There were 72 transactions of this type last year, the most since 2001, and already there have been another 55 transactions in 2011. On the public side of the financing markets, the REITs have made a strong move this past year with 13 publicly traded companies worth $57 billion now playing in this space. The most aggressive has been Ventas, which acquired one of its competitors, Nationwide Health Properties, in a blockbuster $7.4-billion deal, and a number of marquee development brands in the industry, including Cogdell Spencer and Lillibridge. Non-traded REITs were also very active, especially Healthcare Trust of America, which was the most prolific medical office building buyer. Outpatient centers are also becoming more prevalent than the development of inpatient beds. Due to innovative, non-invasive technology and the emphasis on reducing costs, outpatient care will grow 30 percent over the next 10 years while inpatient discharges will be relatively flat. The Centers for Medicare and Medicaid Services controls what gets categorized as inpatient vs. outpatient and they have opened hundreds of CPT codes (Current Procedural Terminologies). The result is that procedures that were once exclusive to inpatient are now being performed in the outpatient arena. Medicare will cut inpatient hospital rates by $500 billion over the next 10 years. Outpatient surgeries now comprise 63 percent of all procedures. In 1980, this number was a mere 16 percent. Cancer centers are also growing, with 90 percent of cancer therapy being performed on an outpatient basis. — By Donna F. Jarmusz, senior vice president for business development, Alter+Care, healthcare division of The Alter Group

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