Longer-Term MOB Fundamentals Spawn Aggressive Small-Cap Bidding

December 8, 2011

While investments in the small-cap medical office building (MOB) niche carry considerable risks and uncertainties, trends in demographics as well as health care practices generally bode quite well for savvy players in this competitive space.

Predictably, opportunity-minded property investors are looking to capitalize on the expected perpetual growth in demand for space in a category where specialists and medical professionals control much of the real estate. And they're often encountering favorable financing prospects for smallish clinics even from recession-battered banks.

Notwithstanding pending phased-in cuts to Medicare reimbursement rates, landlords and lenders rank professional medical practices among the most creditworthy tenants small-cap properties can secure, says broker Virgil Nelson at Cushman & Wakefield/Thalhimer in Fredericksburg, Va.

"As a banker explained to me, doctors nationally have a default rate of something like 1 percent," continues Nelson, who just brokered the $3 million sale of the 18,714-square-foot Spotswood Medical Center, which is close to three hospitals in the Fredericksburg vicinity. The price at which a neighboring property owner outbid various other interested parties factored to a capitalization rate of approximately 7 percent.

Yes, rents and occupancies even in the strengthening MOB space are still below pre-recession levels. But the supply-demand pendulum tends to be tilting toward landlords far faster than in other small-cap business-property categories - and not just in retiree-heavy metros. At $23.75 per square foot, the national rental-rate average for all MOB properties is back within 5 percent of its pre-recession peak, according to Marcus & Millichap. And specifically among small-cap MOB properties, national average rents of $18.16 per square foot are within 10 percent of their cyclical high-water mark, according to Boxwood Means, Inc.

Hence even though MOB vacancies nationwide remain in double-digits at about 11.5 percent - 140-some basis points above where they were when the Great Recession hit - the sector boasts a relatively manageable distress level. Among securitized mortgages, the default rate within the MOB niche is just 3.4 percent, compared to 8.5 percent for office properties generally, M&M VP/research John Chang reports.

Given the sector's dwindled development pipeline, investors vying for small-cap MOB acquisition opportunities around the country likewise realize demand for these specialized spaces may come to exceed supply in numerous submarkets. Indeed, deliveries of MOB space through three quarters this year were off 80 percent from the level seen in 2008 - and even down by double-digits from last year's modest tally.

Understandably, potential tight-supply situations are sparking some new small-scale development activity - and sponsors appear to be securing pre-lease (or pre-sale) commitments pretty handily.

For instance, Keystone Cos. already signed Saint Francis Hospital and Medical Center to two-thirds of the 15,000-square-foot building it just launched at its Dorset Crossing mixed-use development just north of Hartford in Simsbury, Conn. Meanwhile just south of Kansas City in Grandview, Mo., Block Real Estate just opened its 20,000-foot Grandview Medical Building featuring tenants Hickman Mills Clinic, Carondelet Health and Albers Medical Pharmacy.

As Nelson observes, construction lenders are generally amenable to smallish MOB projects boasting solid pre-lease commitments. And when doctors or medical groups are the owner/developers, it's not unusual for lenders to offer 80 percent or higher loan-to-cost packages - and occasionally even full-cost for particularly strong sponsorships.

However even in arguably under-supplied submarkets, it seems doubtful a lot of developers - or more particularly project financiers - will look to aggressively construct spec space before the U.S. Supreme Court rules on the constitutionality of key elements of the national health care legislation known formally as the Patient Protection and Affordable Care Act (likely by mid-year 2012).

Logically more small-cap investors continue pursuing strategic acquisitions as they dissect key tenancy trends in the MOB niche. One entails ongoing efforts to cluster practices that can efficiently serve varying patient needs - with these medical professionals often looking to share space, equipment and perhaps staffs.

Meanwhile, hospitals and medical centers are becoming more significant tenants in MOBs than has been the case historically - likewise often with an eye toward strategic specialty clustering. Hence proximity to a magnetic anchoring institution (or two or three) will likely become an even more significant value-driver going forward.

Throw in the generally favorable lender sentiment and it's no surprise that small-cap MOB trading has been brisk of late - and pretty darned competitive as well. To wit, even though $20 million transactions have been fewer and further between, overall deal velocity was up 10 percent for the year through September, according to M&M's update.

Cap rates for MOBs range from as much as 9 percent or more for Class B properties in tertiary markets and locations, to 6 percent or less for top-notch diagnostic and treatment facilities. The average is in the low-8s. As Nelson is quick to point out, would-be owner-users predictably tend to rank among the most aggressive bidders in many cases.

M&M's analysis highlighted 19 recent sales around the country, eight of them closing between $4 million and $6 million. The average price among this latter group came to just under $220 per square foot - ranging from the $133 PSF for the Lake Lurna Professional Center in Orlando, to $420 PSF for St. Luke's Urgent Care Center in St. Louis.

While the MOB product is facing far less financial distress than offices or shopping centers generally, some investors are managing to uncover potentially lucrative contrarian plays. For instance, a couple of opportunistic players based in Metro Denver are buying up distressed small-cap properties and improving and operating them to attract more medical tenants.

Signature Partners has assembled teams to invest opportunistically, in some cases also partnering with specialist Centum Health Properties. Baceline Investments has likewise been focusing its latest distressed-asset investments on the health care niche - in some cases converting obsolete shopping centers into medical properties.

In the small MOB space, banks today are typically financing acquisitions at rates between about 5.25 percent and 5.75 percent, according to M&M's mortgage banking group. Loan-to-value ratios generally range from 60 to 75 percent, depending on property quality, location, tenant credit and strength of sponsor.

However, lenders and buyers remain quite aware that market-wide MOB vacancy rates vary widely across the country. Phoenix and Las Vegas remain well over 20 percent, with Atlanta still above 16.5. But comps in markets from the Pacific Northwest to Northern California appear to fall with longitude: 7.5 percent in Seattle, sub-7 in Portland, mid-5s in San Francisco down to sub-4 in Silicon Valley.

Hence despite the unstoppable Aging-of-America demographics inevitably boosting demand for health care services - and in turn medical space - small-cap MOB investors are advised to proceed with caution.

Of course it's encouraging that, as Chang notes, more and more people who lost health coverage along with their jobs amid the tough economy have been getting it back as they find new employment. However at the same time, Medicare provider payments are expected to be cut 2 percent annually for a decade starting in 2013 (although that's also subject to political negotiations).

Meanwhile, we can't say for certain whether 35 million-some currently uninsured Americans slated for coverage under the new health care law will indeed see that critical benefit. On the other hand, there's little doubt another 15 million citizens will reach age 65 over the coming decade.

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