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Is Converting Offices To MOBs A Prescription For Success?

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With a high demand for medical office space and an oversupply of traditional office space, why aren’t more offices being turned into MOBs?

America is oversupplied with office space, a good percentage of it functionally obsolete and destined to be torn down or converted to residential or other uses. Thanks to the pandemic, the office vacancy rate reached nearly 20% in March 2024, according to CoStar, and 44% of offices appeared to have negative equity, or property values less than their loan balances owed, according to researchers at the University of Southern California, Northwestern University, Columbia University and Stanford University.

Meanwhile, the medical office vacancy rate is about 7%, according to PwC and the Urban Land Institute, with growing demand driven by the country’s aging population, while costs to build new medical office buildings have soared to $500 per square foot, compared with $100 per square foot for renovation.

Given this, converting some office buildings to medical office space seems to be just what the doctor ordered. Unfortunately, not just any vacant or mostly vacant office building is a viable candidate for conversion.

MOBs: A Cycle Of Retrofits Followed By Ground-Up Construction

As major teaching hospitals like RUSH University System for Health planted their flag in the suburbs to be closer to patients in the late 1990s and early 2000s, we saw a trend of doctors outgrowing their space in hospitals and seeking suburban offices to set up shop. A spate of retrofitting older offices for that purpose was followed by more ground-up construction between about 2008-2020.

Within the past 18 months, however, rising costs for land, materials, labor and capital has meant almost nothing is being built new. Projects coming online now were greenlit two years ago. This is playing out as obsolete office buildings — particularly in suburban locations — are struggling with high vacancy. For those that can be acquired well below replacement cost, conversion to medical office space is still a sound investment.

Some office-to-MOB renovations will depend on the practices that will be in the building. For example, for any imaging center that takes X-rays, lead is needed in the walls so radiation can’t penetrate them. MRI machines typically must be on a slab, on the ground floor, or the floor will need to be structurally reinforced. And any services that involve the use of a gurney require wide elevators; most ‘70s- and ‘80s-era office buildings don’t have them.

The Big Three: Consumer Appeal, Mechanicals, Parking

Beyond that, whether an office building is a good candidate for conversion depends on three major factors: the “retail”-like character of the building, including “curb appeal,” visibility and access; sufficient building mechanics; and ample parking.

1. Retail-Like Appeal, Visibility And Access

As the healthcare industry has become more competitive, the ability to attract and retain patients has become increasingly important. In a recent McKinsey survey, 90% of healthcare provider executives named “customer centricity” as a top priority. Healthcare providers of all kinds are studying retail, tech and other consumer sectors for ideas, as McKinsey notes.

Thus, any aging, dimly lit office property will not do. Today, patients expect a choice of providers in convenient, attractive settings. Older offices may need a nice buildout, brighter colors and better lighting. Often, MOBs now are adjacent to other healthcare providers, retail and even residential buildings for convenience.

Visibility and access also are key to attracting not only patients, but also staff. A 150,000-square-foot office-to-medical office conversion called ArlingtonMed in Arlington Heights, Ill., a suburb of Chicago, is passed by thousands of cars every day, with signage visible from the adjacent expressway. It is part of an 18-acre, mixed-use, master-planned development that includes retail and residential buildings, which will increase traffic and make it a destination — or home — for more patients. The size of the old office building and its configuration also make it a particularly strong candidate for larger providers, offering 10,000–20,000 contiguous square feet. The building has large elevator banks at the core, allowing office space to be at the perimeter and afford views and natural light.

2. Mechanicals

Medical office buildings tend to require more heating, cooling, electrical and plumbing muscle than regular office buildings. A typical 1970s office building conversion, for example, will require more plumbing if additional restrooms are needed to accommodate the patients from all the practices occupying the building.

For basic office and medical equipment, an aging electrical panel can be upgraded. But if specialty equipment will be used – like laser, surgical, EKG, nuclear medicine or other machines — more robust electrical and a backup generator meeting complex state codes will be needed, because these machines can’t go down in the middle of a procedure.

3. Parking

MOBs typically require drive-up and drop-off spaces in front of the building and more parking than regular office buildings, especially in the suburbs, where people tend to be more car-dependent. With doctors, nurses, and other staff as well as a steady flow of patients visiting, the ideal parking ratio for MOB is five or six spaces for every 1,000 square feet, versus four for a regular office building.

Older, low-density office buildings in the suburbs typically are “under-parked,” unless they have a parking deck or can build one. This was true for ArlingtonMed. Located in the former home of a daily newspaper, it had a covered parking deck that we’ve torn down to build a new and larger structure with direct access to offices.

The Final Prescription: Choose A Specialist

Despite the long list of requirements, some buildings are good candidates for conversion to MOB. Developers considering a conversion, or providers seeking space, should tap a broker with expertise in MOBs — akin to going to a medical specialist — to help assess which offices can be revived through renovation, and which are beyond saving.

 

Source: HC+O News

Medical Offices Ready For Spike In Record High Number Of Insured

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The total number of uninsured in the US has reached a new low and the medical office asset class stands to benefit from it, according to Marcus & Millichap’s 2024 National Investment Office Forecast.

This robust demographic will need and seek more visits to healthcare providers, subsequently driving tenant demand for medical spaces, particularly in markets such as Louisville, Seattle-Tacoma, Portland, and Boston.

Those areas have sub-6.5 percent vacancy rates. Texas has the largest percentage of uninsured residents nationwide and carries an office vacancy rate above 15 percent in San Antonio, Houston, and Dallas-Fort Worth.

Arizona and Nevada, too, have high uninsured populations, with vacancies in Tucson, Phoenix, and Las Vegas above 12 percent.

In Florida, some metros notably refute this trend as the state’s uninsured rate is over 11 percent, but West Palm Beach and Miami-Dade have some of the lowest vacancies among major U.S. markets. Medical office projects are slated to constitute approximately 70 percent of the space completed in Tampa this year.

In 2023, fewer medical office assets changed hands than in 2022. However, transaction activity is above the 10-year average in most regions. An aging population will necessitate medical office expansions long-term.

Marcus & Millichap cited a challenged borrowing environment and said this pressure will likely ease in 2024 as many investors expect interest rate cuts.

“Additionally, private investors have become more active in the space as institutions pull back,” according to the report. “Deals in lower price tranches have increased the use of seller financing in some cases, circumventing lender-based headwinds.”

The report said that the new supply would fall to a nearly two-decade-low construction as it will be reduced by 8.5 million square feet to approximately 500,000 fewer square feet of medical office space this year compared to last. This will push total inventory up by just 0.7 percent.

“Limited additions will prevent any major supply headwinds going into 2024 and beyond as new starts decrease as well,” according to Marcus & Millichap.

Vacancy rates will climb by 20 bps to about 9.8%, according to the report. Meanwhile, medical office tenants will still grapple with a prevailing labor shortage, complicating operator expansion plans.

The average asking rent for medical office space will rise by 1.3% to $23.40 per square foot by December as new buildings come online, reaching a more than two-decade high. Metros such as West Palm Beach, Salt Lake City, and Portland are expected to lead the nation in rent growth, concurrent with local vacancy rates below the national average, according to the report.

 

Source: GlobeSt.

What Drives Investors To US Healthcare Real Estate

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US Healthcare real estate continues to buck the work-from-home trend that has stifled growth in office properties in all major economies post-Covid-19.

This is due to a number of factors, including the one-on-one nature of medical care and long-term growth trends in the medical sector in the US, which ensure that rentals and capital values for MOBs stay relatively stable.

The medical office market has consistently seen annual rent increases since 2012. Favourable lease terms support minimal tenant turnover, creating steady rental cash flow, thus benefiting both vacancy and rent trends. According to a report from Colliers, despite the rise in average rentals in MOBs, vacancies have declined to 8%, contrasting with vacancies in the office sector in general, which stand at 15.1% and growing.

Rentals for traditional offices usually rise faster than those for MOBs in upturns but MOB rentals tend to be more resilient during downturns. Since 2000, growth in MOB rentals has averaged 1.8% a year compared with 1.4% average growth for traditional office space.

Advantages Of Healthcare Real Estate Over Other Property Investments

These advantages arise due to several underlying drivers of MOBs.

One is that since the Affordable Care Act was passed in 2010, the number of Americans with health insurance has risen steadily. These trends are expected to continue. In June last year, the Office of the Actuary Centres for Medicare & Medicaid Services forecast that from 2022 to 2031 average growth in national health expenditure at 5.4% would outpace average GDP growth at 4.6% in the same period, resulting in an increase in the health spending share of GDP to 19.6% in 2031 from 18.3% in 2021. By 2031, 90.5% of the US population will have medical insurance (in 2009 it was 85%).

Another driver is the ageing US population. The number of people aged 65 and older in the US has risen by about 3% a year over the past decade, and older people are generally more likely to use medical services such as routine check-ups, dental cleaning and visiting specialists – which are increasingly happening in medical offices rather than hospitals.

Healthcare real estate is different from most other types of office building in that healthcare tenants are readier to sign long-term leases because they build up a reputation with patients in their vicinity and often require significant set up costs especially in the case of imaging, laboratories, theatres, oncology and even dentistry. For investors in these buildings, long leases provide predictable cash flow, lower tenant turnover (and associated sign-on costs) and lower vacancy rates.

Longer-Term Outlook For Healthcare Real Estate

While demand for healthcare real estate is growing, supply is restricted as banks are pulling back lending in an environment of high interest rates and construction costs, which deters new developments. In this environment, opportunities also arise to buy distressed assets at attractive entry points that will deliver superior returns over the long term.

According to a survey of 37 institutional healthcare investors by US-based management consultants KaufmanHall, which was published end-September 2023, almost 90% of survey respondents reported that occupancy rates had improved or stayed the same over the preceding 12 months. 86% of respondents expected their MOB portfolios would perform similarly or better in 2024, and almost the same proportion expected annual rentals to rise by 3% or more for new or renewed MOB leases.

Although the majority of respondents said tenant improvement packages were having to become more aggressive to persuade new tenants to sign or existing tenants to renew, only 16% said they had had to offer inducements such as a rental-free period. KaufmanHall suggested demands for better sign-on deals probably reflected rising costs due to inflation rather than more fundamental shifts.

“In short, the survey results indicate a market with significant fundamental strength despite capital market challenges. Cap rates are up, meaning valuations are down, and transaction volumes are also down. Past experience suggests that this dynamic may offer a significant opportunity to buy high performing assets at attractive historic relative valuations,” KaufmanHall said.

Conclusion

Steep increases in inflation and interest rates over the past couple of years have demonstrated that property is not always a safe haven. Investors in over-geared properties, or those where lease agreements provide no protection against rising tenant costs, are feeling the strain. There are an increasing number of distressed sales in the general office market. This is an environment where investors should pick their sector very carefully. Well-maintained and well-tenanted healthcare buildings in good locations, managed by an experienced team, stand out in this market.

 

Source: BizNews