Real Estate Forum - November 2008

the first three quarters of ’08, $3.3 billion worth of product traded hands, versus $3.9 billion for the same period in 2007, according to Real Capital Analytics. That 17% decline in activity pales in comparison to the roughly 50% plunge in volume for the overall market, says Dan Fasulo, managing director of research for New York City-based RCA. “The credit crunch has been very democratic, impacting all investors, all markets. But it looks like this niche is definitely outperforming the rest of the marketplace,” he says.

By year’s end, total sales volume for medical office product is forecasted to pencil in at somewhere between $4.5 billion and $5 billion, according to Marcus & Millichap Real Estate Investment Services. Though that estimate is a marked difference from the firm’s earlier year-end projection of $6 billion, the radical shift in the financial markets has altered the outlook for the entire industry.

Through the first half, “high-quality medical office product was certainly trending into the low- to mid-6% cap rate range,” says Alan Pontius, managing director of Marcus & Millichap’s healthcare real estate group, who is based in San Francisco. “Today, there might be an opportunity to hit that mark if financing were highly favorable. However, it is pretty difficult to trade at that level, so yield expectation in a cap rate context is probably up 50 to 75 basis points.”

Fasulo, too, has noticed some upward pressure on cap rates, but notes, “Of all of the property types, the one that has had the smallest upward movement has been medical office because it’s perceived as a safe haven.” During the economic downturn of 2002-03, he says, investors began chasing medical office because of its solid roster of credit tenants occupying space under long-term leases.

Lease terms for medical office are often 10 years or more compared with five years or less for traditional office space. According to a recent report by Grubb & Ellis, medical office offers higher occupancies and lower turnover rates. Tenants of these facilities, such as physicians, have a vested interest in remaining where they have an established patient base. They also tend to pour hefty sums into their facilities.

“When they invest millions of dollars up front to build out their office space, they’re not going to sign a five-year lease and then leave all of this stuff behind,” says Fasulo. “After a developer signs these tenants, the asset becomes very attractive to third-party investors, who see stable cash flow for a very long time.”

Minneapolis-based investor the Geneva Organization was drawn to the reliable performance of medical office when it entered the market in 2006, says Garrett Farmer, a partner in the firm. “Our investors are looking at stability, predictability

and cash flow, and a long-term lease will provide that for them.” Geneva recently nabbed its fourth medical office property: the DaVita Dialysis Center in St. Louis Park, MN. The 8,000-sf single-tenant building is occupied by Total Renal Care, which signed a long-term, triple-net lease with renewal options. Terms of the deal were not disclosed.

Farmer points out that when a credit tenant is involved, “Medical office is slightly more competitive than traditional office, probably to the tune of 25 to 100 basis points in both cap rate and cash-on-cash returns.” Still, traditional office investment generally garners Geneva a cash-on-cash return between 6% and 12%, he says, while medical office is between 5% and 9%.

“The easiest way to define medical real estate investment is slow and steady,” says Danny Prosky, executive vice president of acquisitions for Grubb & Ellis Healthcare REIT of Santa Ana, CA. “With healthcare, you assume that your deals are fairly well occupied when you buy them. You also assume that you will grow your rent 3% a year, which is why you see higher cap rates than other property types.” As a result of risk-averse investors taking greater interest in the niche market, he says, there has not been a drastic swing in cap rates.

“Most of our deals show unlevered internal rates of return in the low double digits, but we’re pretty conservative,” Prosky says. “When we buy assets, we assume very long holding periods, usually around 10 years. From our perspective, the deal flow has almost held steady. I haven’t seen much of a drop in healthcare sales during the last year. Over the course of the past several weeks, however, even this resilient sector has experienced some weakening. The long-term prospects for medical office remain remarkably strong, but it will clearly experience a short-term slowdown until the credit markets stabilize.”

Buyers who are less dependent on the capital markets, like Grubb & Ellis Healthcare REIT, are among the more active investors in medical office. In late September, for example, the firm picked up a collection of assets dubbed the Oklahoma City Medical Portfolio for approximately $29.3 million from Deaconess Portland MOB LP. Located on the Deaconess Hospital campus in Oklahoma City, the package comprises two buildings. The three-story 5701 N. Portland has 61,000 sf and is 86% leased to 17 tenants. Sixteen tenants occupy 96% of 5401 N. Portland, which has roughly 126,000 sf on six floors. With the ink barely dry on that deal, the REIT snapped up Medical Portfolio Four a week later for $48 million. The Cirrus Group sold the five buildings located in Arizona, Ohio and Texas, which aggregate 226,000 sf.