Discussing the possibilities and future at the intersection of healthcare and commercial real estate
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Today’s episode is my interview on the Rent to Retirement podcast. I am asked to dive deep into the real estate fundamentals of healthcare properties. The hosts ask me questions on why this asset is attractive from an investor and owner / user standpoint. We discuss lease rates, lease terms, lending, and tenant improvements from both vantage points.
[1:34] How I got started in real estate
I live in Phoenix, AZ, which is a high growth market. Commercial real estate has always been a very healthy industry because companies frequently expand and move into the area. I started my career as a developer and I developed, managed, and leased a medical office building. I was in the leasing department for a couple years, and then moved to a third-party brokerage and did the same thing. Then, I went on to national brokerage, and finally started my own firm late last year. I started doing a lot of landlord leasing and then moved into sales and investment.
[2:39] My decision to focus on healthcare real estate
My first job was in commercial real estate, and when you go into commercial real estate you pick between the “five food groups”: office, industrial, land, retail, or multi-family. I definitely felt more attracted to office, and then at my first job the firm focused on healthcare real estate. I think what drew me to it is that it is a demand-driven and mission-critical asset class. It’s very purpose-driven, because physicians can’t operate out of their houses. They have to have facilities.
I also enjoyed working with physicians. They need information quickly, and they tend to make decisions quickly. They appreciated the help they got because they have a day job that is non-real estate related. When you’re going through a real estate transaction, there are a lot of decisions to be made and someone has to tell you the economic impacts of those decisions. I enjoyed advising them through that process and synthesizing all the information to help them make decisions.
[4:44] The scope of work for Doc Properties
I advise third-party investors in either selling or purchasing medical office buildings. I work with physician owners, and typically they want to own the building for their practice. There are a lot of economic benefits that come from owning, and the reimbursements when they own a facility are higher than if they are renting or if they are in a hospital. There are also a lot of operational benefits to owning a facility. It is a wealth-building machine, and it’s a long-term investment. My clients are investors or physician owners who are going to use the property. I do have a lot of physicians that want to invest in properties and maybe not occupy them, as third-party owners.
[7:08] Financing retail properties
There is a retail trend in healthcare real estate. A lot of physicians are looking at retail space for their practices. There has been a lot of shift in retail space, likely related to the “Amazon effect”. Medical office users have been interested in the space, because they offer good parking as well as visibility. A lot of practices are looking to have signage that is viewable from the street. Hospitals are putting urgent cares on corners, just like drugstores.
There is a hub and spoke model for healthcare, and they are trying to get outpatient care out of the hospital. They have built these outpatient clinics and urgent care centers in the communities, so patients don’t have to drive as far. There is a lot of drive-by traffic, and it’s easy to get to. Those things are driving the current retail trend.
[11:37] The impact of the COVID-19 pandemic on healthcare real estate
Medical office has probably been the healthiest throughout the COVID-19 pandemic. Rental payments have stayed in the high nineties for most of the investors I have spoken to. The doctors still had to operate, and many practices qualified for the PPP loan so they were able to pay. Some shutdowns occurred with elective surgeries, but within six weeks it seemed like they were ramped back up in Arizona. The physicians I speak to don’t work from home, and they were in the office every day. They tried to keep their staff healthy, and they continued to treat patients.
[15:10] Evaluating a building that has medical use from a tenant perspective
The attractiveness to medical office and its resiliency is the long-term leases. The reason there are long-term leases is because a landlord has to provide a significant amount of capital for a tenant improvement allowance, because the tenant has to supply a lot of capital. In a second-generation office building, you can probably budget $15-$20 per square foot for re tenanting the space. In a second-generation medical office, I would say you cannot budget less than $50 per square foot, because there might be some changes to plumbing and electrical. It starts to become expensive because each particular medical office has a specific purpose for that space.
If you’re a family practice and you’re going to occupy a space that was previously optometry, you might not have sinks in all of your exam rooms. There is a plumbing expense there. The exam rooms themselves could be re-used as well as the waiting room and reception area, but things may have to be completely refigured in order to make that space appropriate for a family practice.
When you go in there, you have to analyze how much money you anticipate having to put into the space. If the entire cost is $50 per square foot (which is likely on the conservative side) for an easy build out. The general cost for medical space used to be $80 per square foot, and now it could be between $100-$120 per square foot. You as a landlord have to offer $75 or so and then you can ask for 10 years.
[19:57] Financing healthcare real estate
Typically in medical buildings, these rates are higher than general office to account for the tenant improvement costs. Personal guarantees and making sure that tenants are financially viable is a huge part of that, because you need to make sure that outlay as an investor is guaranteed in some way.
For physician owners, SBA loans go up to $5 million. They require that whoever is taking out the loan occupies at least 51% of the property. That works for some practices, and some have been doing this over and over again. They have a banking relationship and they can get conventional lending as well. Just like any other business, they like to have two years of financial history. SBA is typically the lowest cost of capital for healthcare groups. If they want to do a bigger building and they need more financing, there are a lot of people in the space that do joint ventures. They lose some percentage of ownership, but joint ventures come in with private capital and they specialize in investing in the medical office asset class. They can analyze the opportunity in the market and the physician group really effectively and efficiently.
[24:46] Whether or not surgery centers are becoming a saturated market
I don’t think surgery centers are going away. There are a lot of surgeries that don’t need to happen in the hospital, as their purpose is to be acute care facilities to treat trauma and perform more complicated surgeries. More and more, hospitals are understanding that to be financially viable they need to concentrate on acute care while purchasing family practices and and other practices in order to keep the referrals coming.
I think surgery centers are going to continue to be successful because if you are a physician, you run the risk of being bumped for a trauma surgery in a hospital. Physicians get higher reimbursements performing surgeries in their own outpatient facilities. In addition, surgeons want to be as efficient as possible. Typically, the surgeon will plan back-to-back surgeries one or two days a week, and then they will do pre- and post-op visits in their clinical office on the other days. If you are dependent on a hospital surgery room, you aren’t able to be as efficient and you have to wait to make sure the operating rooms will be available.
[27:52] The importance of proximity to hospitals
This goes into a practice’s business plan and business model. For instance, if you are an OBGYN you are typically located near or sometimes on hospital campuses because you have to get to the hospital quickly. If you are owned by a hospital, they will put you as close to the hospital as possible. A lot of orthopedic groups are now outpatient, so they are no longer dependent on the hospital. While they might want to be in the vicinity of the hospital, they don’t necessarily need to be on campus.
[29:41] The changing dynamics in healthcare real estate
I think that as more and more procedures are being moved, outpatient clinics and facilities are going to be the wave of the future for a lot of practices. Imaging equipment is incredibly expensive and getting more so. These centers require a lot of tenant improvements, and they’re likely to have to do it themselves rather than depending on the landlord. If they own the building, however, they get the economic benefits and they can refinance it as well. They have more flexibility.
As technology increases and groups have to purchase more expensive equipment, I think their build outs have to become more specialized. It’s going to be hard for them to lease. There are investors that do allow physician ownership in their buildings, but the build outs are becoming so specialized that it’s hard for them to make it make sense.
[33:34] “Double dipping” in physician ownership and private practice
There are Stark Regulations, so typically they have two separate LLCs. One LLC owns and operates the building, and then another is for the practice. The practice will then sign a lease with the LLC that owns the building, because sometimes not all of the physicians in the practice want to own the building. If they own the building they lease it to another group, they can’t give that other group a special deal for leasing space. It has to be at market conditions. This is where you want advice from somebody in the market, because you have to really understand market rates. You want to make sure you are in compliance with the legal side of things.
[35:47] When medical use may not be successful in a particular space
First, you want to buy on sound real estate fundamentals. Medical practices, like any business, have to purchase property and make real estate decisions that make sense for their particular practice. They need to think about making money through insurance reimbursements, because reimbursements keep getting pushed down and rents are going up. They really have to take a look at what costs they can afford for either the mortgage that they’re going to have to pay or the least expense that they’re going to have to pay and factor in all the costs. Taxes go up, but if they own the building it won’t get reassessed. With office condos being popular now, it can take a long time to recoup costs.
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