There are several demographic and legislative issues that have the potential to influence demand for medical office buildings, and in doing so, impact the performance of traded and non-traded REITs that own these properties.
REITs have yet to feel the full effect of these demand influencers, which include healthcare reform, shifts in the way healthcare is delivered, potential future physician shortages, population growth, an aging population, and decreasing Medicare and Medicaid reimbursements. These influencers are opposing forces — some of them create demand, while others present challenges to the healthcare providers that occupy medical office buildings, also known, perhaps unflatteringly, as MOBs.
Medical office buildings are different from traditional office buildings in that all MOB tenants are healthcare-related. MOBs can be located on hospital campuses or off-campus, and typically house a variety of medical practices with differing specialties in addition to ancillary and support services such as laboratories, imaging and surgery centers and even pharmacies.
“We've been favoring the REITs that have more exposure to medical office because the tenants are more private-pay than Medicare and Medicaid,” notes Jana Galan, a research analyst with Merrill Lynch.
In fact, most analysts expect MOBs to perform well over the next few years. “Medical office buildings should see steadily escalating NOI [net operating income] in the foreseeable future,” according to an August 2011 report issued by Green Street Advisors.
MOB Exposure Varies
High rents, long-term leases and strong tenant retention make MOBs a popular investment, and there are several REITs that have exposure to MOBs, although there are no REITs that only own MOBs. Even those with the highest concentration of MOBs — Healthcare Realty, Cogdell Spencer Erdman, Healthcare Trust of America and Grubb & Ellis Healthcare REIT II — own other out-patient facilities, such as rehabilitation and surgery centers.
In addition, MOBs are part of the investment strategy for most healthcare REITs. (See May issue of Registered Rep.) And a handful of traditional office REITs own a small number of MOBs — Duke Realty and Douglas Emmett Inc., for example.
Because MOB ownership crosses multiple REIT sectors and differs from REIT to REIT, it's difficult to make comparisons. For example, the nation's largest healthcare REIT, Ventas Inc., owns 230 MOBs totaling 14 million square feet. MOBs account for roughly 11 percent of the Chicago-based company's portfolio and generate $140 million in net operating income.
In contrast, Nashville, Tenn.-based Healthcare Realty, which many analysts consider a pure-play MOB REIT, owns 203 MOBs totaling nearly 9 million square feet. MOBs account for 85 percent of the REIT's portfolio. Meanwhile, Duke Realty owns 29 MOBs totaling 2.9 million square feet — less than 1 percent of its 141 million-square-foot portfolio, which includes traditional office, industrial and retail in addition to MOBs.
Reform's Uncertain Impact
The Patient Protection and Affordable Care Act (PPACA) will create additional demand for healthcare services, but its impact on MOBs is less clear.
The current legislation will bring coverage to as many as 32 million previously uninsured individuals. Americans who previously used emergency rooms in acute care facilities to deal with their medical issues will transition to primary care physicians, who are located in MOBs. In addition, healthcare reform emphasizes preventive care and wellness, which is handled by primary care physicians.
Most healthcare and real estate experts expect demand for MOBs to increase because of PPACA. Marcus & Millichap, for example, estimates another 62 million square feet of medical office facilities by 2014.
It's important to note, however, that the U.S. is facing a potential future physician shortage. Reports suggest that we'll experience a deficit of 125,000 to 150,000 doctors by 2020. While the shortage will be evident across all medical specialties, it will be most acute with PCPs, according to Dr. Paul Sanders, a family practice physician based in Dallas.
During a recent MOB conference, Sanders participated in a panel titled, “Physician Practice Dynamics in the Wake of Healthcare Reform: A Roundtable.” He noted that there has been a 20 percent to 40 percent drop in primary care physician compensation, driving new medical students to seek out other specialties. “Eventually, there won't be any primary care physicians if something doesn't happen,” he warned. “That will change the way buildings are built, and the space needed.”
Sanders pointed out that compensation has decreased so precipitously that many primary care physicians can no longer afford the medical offices in which they occupy. “We reduced our space by 45 percent because we couldn't afford it,” he said, referring to his family practice.
Improving Property Performance
Recent market statistics, however, indicate that demand for medical office space has increased over the past 12 months. Marcus & Millichap reported that the vacancy rate for MOBs nationally decreased 50 basis points in 2010 to 11.8 percent. That demand didn't translate into increased rental rates however: Rents dropped 1.4 percent.
The commercial real estate services firm forecasts the vacancy rate will continue to trend down this year, sliding 60 basis points to 11.2 percent with more than 10 million square feet absorbed. Improving occupancy will spark “asking” rent growth for the first time since 2008. During 2011, U.S. asking rents will tick up 0.9 percent, with the Northeast and Texas leading the way.
Both areas will register asking rent increases averaging between 1.5 percent and 2 percent.
Rich Anderson, a REIT analyst with BMO Capital Markets, says that MOBs have historically not provided a lot of internal rental rate growth. “Very often, REITs have equity partners in the form of the actual physician tenants, and they've chosen to be less aggressive in pushing rents so they retain physicians instead of angering them,” he explains. “That's why I think growth is more likely to be driven by development and acquisition activity.”
In fact, MOB development activity is increasing, unlike construction for traditional office properties. This year, MOB developers will deliver 7.9 million square feet of new inventory. Ventas, for example, is among the most active developers — the REIT's acquisition of Chicago-based Lillibridge and Nationwide Health Properties gives it access to a robust development pipeline. Likewise, several other REITs have significant MOB projects under development.
Proximity to Hospitals
Unlike general office REITs that prefer to invest in large metro areas, REITs that invest in MOBs are more focused on the properties' proximity to healthcare providers.
“When it comes to real estate investing, the common mantra is ‘location, location, location,’ and that applies to medical office buildings, but not in the same manner as it does with other forms of commercial real estate,” explains Danny Prosky, president of Grubb & Ellis Healthcare REIT II, which owns 32 MOBs. “When we evaluate a property for potential acquisition, the most important thing to us is the strength of the associated healthcare system, not the geographic location of the property.”
Most REITs prefer to invest in on-campus MOBs. Many MOB owners contend that on-campus MOBs or those that are immediately adjacent to hospital campuses have an advantage over off-campus MOBs; demand is stronger and competition is limited because the healthcare system controls the amount of medical office space on its campus.
Industry experts note that physicians are willing to pay more rent for the convenience offered by these buildings. In fact, on-campus MOBs typically generate a 10 to 15 percent rent premium over buildings that are not close to hospitals.
By the same token, however, the healthcare system also puts other restrictions in place. For example, the hospital may have the ability to veto specific MOB tenants, making it more difficult for the owner to fill the property, says Mr. Lynch's Jana Galan.