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EP81 - Healthcare Investments, Medical Offices, and Commercial Assets!

This week Trisha is sharing an interview she did on the Real Estate Investing for Cash Flow podcast by Kevin Bupp. They discussed healthcare real estate, why it is attractive, and what investors need to know before entering into the asset class. In addition, they touch on sale leasebacks, some pandemic effects, and a general overview of the industry. 

Schedule a healthcare real estate investment strategy call with Trisha

In this episode, we talk about…

[2:01] Trisha’s background and how she got her start in the healthcare real estate industry

Trisha started her career in-house at a developer that only did healthcare real estate medical office buildings. They would develop and lease them, and then hold them for some time before selling them. Trisha was part of the leasing effort there, and she really learned a lot about the asset class from the ground up. She started in leasing, then moved to sales, and now she can do pretty much any deal related to healthcare real estate. She can advise her clients based on the rent roll, the type of tenants that are there, the capital improvements that would be made, and whether or not it looks like a good investment going in based on their exit strategy. Trisha worked there for two years before she went to third-party brokerage. She has now been there going on twenty years, total.  

While she bounced around a bit initially, once she got into the business she really enjoyed working with the physicians and the different healthcare companies. It is a mission-critical, demand-driven type of asset class. Coming out of the pandemic, it is one of the most resilient asset classes because doctors need a place to perform procedures and to see their patients. Telemedicine is a great tool, but other than having a couple of telemedicine rooms being built, Trisha does not see it dramatically changing the landscape of healthcare real estate.  You can’t have surgeries and other medical procedures done virtually. So, Trisha was drawn to the idea that there is some purpose behind healthcare real estate and that it serves the greater good. In her job, she really does help provide healthcare services to communities.


[5:15] The impact of the COVID-19 pandemic on the healthcare real estate market

Looking back at this point, the pandemic was a short-term blip in this market. A lot of the tenants did qualify for a PPP loan, so they were able to get through it. In addition, a lot of the landlords really helped educate their tenants on doing that in order to make their payments. A lot of landlords could give their tenants three months of abatement and then increase the lease term by X amount, depending on the landlord. It was deferred income for the landlord, but they could ultimately build value by renegotiating some of the lease terms.

At the end of the day, if you own a building (and most likely have debt on it), you still have a payment that has to be made. For some that didn’t have a lot of operating capital for unforeseen events, there was definitely some panic. Trisha’s phone rang a lot, and she had deals being transacted that went away. They did eventually all come back, but some disappeared or paused while everyone figured out what was happening.

For physicians, the lack of income during the pandemic was a source of panic as well. Trisha also got some calls about what they could do in those circumstances. Luckily, where Trisha lives in Arizona and from what she heard from various other parts of the country, there was about a six-week break in elective surgeries before things started ramping back up again. It did bounce back, and it was ultimately a small blip. At the time, however, it was a very long six to eight weeks. Now, the landlords Trisha talks to are thriving. The tenants have recovered, and they are getting rent payments in on time. A lot of them did receive some of the PPP, and everything is doing really well at this time.

[8:20] Pricing adjustments related to the pandemic

One transaction Trisha was involved with came back as it was – no price adjustment, just re-engaged. One tenant asked for a rent abatement at the eleventh hour right before closing, so that was an interesting twelve hours. Ultimately, the investor buying it asked for some coverage of the rent for an additional month as part of the negotiation.

Right now, the cap rates for medical office buildings are incredibly aggressive and incredibly low. If you have a decent medical building and five years or more are left on a weighted average lease term, it is sub sixes in Arizona and sub fives and fours in California. People are looking to place their money in a resilient asset class that is unlikely to fluctuate. While the pandemic was starting, Trisha thought it was going to take about a quarter or two to recover. As we got into summer 2020, they started to hunker down for about a year of getting out of it or seeing some light at the end of the tunnel. These assets and this cash flow is ten years. Let’s say we’re in the pandemic for three years – there are still seven years of cash flow after that. Trisha had confidence that medical office real estate would bounce back. You’re playing the long game when you invest in this kind of real estate.


[11:22] Sale leaseback strategies

Trisha has done several sale leasebacks in the course of the past year – two as the pandemic was starting and several more since then. Right now, if you are a healthcare practice and you have several sites and want to monetize those assets, a sale leaseback transaction may be a good consideration. You could cash out now and pay rent for the next 10-15 years in order to get that equity out. Often, these opportunities don’t even get on the market. Trisha may hear of one becoming available and she has a handful of investors she goes to who she knows love sale leasebacks and who perform. The opportunities go really quickly.

There also has to be some skin in the game. You typically have to sign a personal guarantee for the lease, because the cash flow needs to be guaranteed. In addition, you need to sign at least a ten-year if not a fifteen-year agreement. Investors will not just buy you out; there are some strings attached.


[14:39] Going after value-add healthcare projects

There are different things that different investors look for.  Publicly traded REITs need “cleaner” properties in the sense that they have to pay dividends to their shareholders. So they’re really looking for core plus cash flowing properties where they don’t have to come in and do a lot of work to either lease it up or do any capital improvements on the physical properties. Then they go along the spectrum from that to a private investor. He doesn’t have a board he has to present to. Maybe it’s his company, and he might have some business partners. They can get a property that has some vacancy, and maybe some tenants with whom they need to negotiate some leases. Maybe the building is operating as efficiently as possible, and there is some opportunity in the operating expenses to get those under control.  

For example, if the building needs to be painted or the parking lot needs some maintenance or a couple HVAC units need to be replaced, and there is a little bit of vacancy, he can go in and buy it at a little off the market price. Then, he can really add some value. This is called value-add because he can add the value and sell it for more than what he bought it for.


[17:30] Converting retail or office assets into healthcare properties

Trisha thinks that retail space is easier than office space, and she has done an adaptive reuse as long as there is parking. She shares about an adaptive reuse of a Walmart that had started a neighborhood market concept that didn’t succeed. They did a huge disposition of a ton of assets nationwide, and there was one that her client liked because they had some back-office space plus a clinic and then they had some space to lease. It had excellent parking.

Healthcare companies are looking to make it as easy as possible for patients to see them and to have visibility, so she does see that medical practices will take advantage of some retail properties. For office space, it really depends. It depends on the age of the building, whether the building has separately metered electric, and on the parking situation. The biggest thing when it comes to converting office to medical is that it has to be bought right because of the plumbing requirements of going in and putting in sinks in exam rooms. You might be able to keep some common areas, hallways, and bathrooms. All the spaces inside would have to be completely gutted and built out for a medical office which has a high cost. So if an investor is looking at an office building to convert it to medical, they have to make sure that they are capitalized right. They would have to buy the property and underwrite it really well so they understand the cost of additional investment that is going to be required in order to convert it.


[21:10] Common mistakes in healthcare property management

Investors hear “medical office” and think about the great returns and long-term leases. They want to get into medical office real estate without really understanding what it takes, where the lease rates need to be, and how you need to manage it from an operating expense standpoint. You really have to understand the property before you buy. You have to understand the tenants, review their financials during the due diligence process, and make sure that they are going to be able to make the rent payment along with all the financial obligations that they may have.

If an investor has never owned a medical office property before, they tend to get in saying that they are only going to spend $10-15/square foot to improve it. Even in second generation medical office buildings, especially right now with construction costs, your starting point is probably $50/square foot in tenant improvements. They might also get into  a place where the tenants can’t fund TIs, therefore they can’t make these lease deals. So they don’t have tenants paying the rent, they defer maintenance on the building, and it just sort of spirals downhill from there.


[23:46] Reflecting on a challenging deal

Trisha aggregates a couple of deals together because they have the same theme. Physicians are always looking for passive income, as they should. They work really hard and reimbursements are getting less and less. They work all day, and they see patients every 15-20 minutes or are in procedures. They are really looking for some passive investments. One thing they like to do is get together with a couple of their buddies and develop a building where they plan to become their own tenants. 

The first question Trisha asks going in is, do you actively practice medicine right now? If you still do, then owning your real estate as a completely separate and additional second job that you’re going to take on (or hire people to take on) is recommended. She recommends outsourcing because a property manager can be calling and getting quotes from vendors all day, and then present you some options as the owner. Trisha advises physicians on the best way to own the property and on all the costs involved. She also supports them in the underwriting process, so they can see exactly what it means from a financial standpoint when they decide to sell it.

Sometimes there will be three to five partners and one of them is the person who raises their hand and says they will manage the property from a day-to-day perspective. They might have a handyman or a list of vendors.By the time they talk to Trisha, however, they often want to free up some of their time. They don’t want to manage the property and be a tenant.

Some are more sophisticated real estate owners than others, and Trisha gets the gambit, but operating expenses are a really big thing. Nobody wants to talk about it. It’s not interesting or sexy to talk about how much it costs to maintain an HVAC system. Operating expenses, however, can kill you. They can also really add value to your building if you can manage them properly. A lot of physicians get the invoices and pay them, but when you really get underneath it you will learn there are many ways to pay operating expenses. You have to know if it’s a triple net or a modified gross on a base year. You really have to dive into the financials of the building and the financials of the tenant.

It takes time to sort through everything and make sure you understand everything about the property. You have to understand how it operates, and think about how to improve it in order to get the highest value. The challenge is that you’re usually doing that in the morning while they are on the way to the clinic, or in the evening when they are on their way home, or sometimes in the middle of the day in a break between patients. You have to talk really fast, have really succinct information, and offer decision points so they can say yes or no. 

Links to resources:

Kevin Bupp

Real Estate Investing for Cash Flow Podcast

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