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What’s Behind Medical Office Buildings’ Strong Trajectory

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One of the US’ fastest growing industries, healthcare spending reached almost $3.5 trillion annually in 2017.

The US Centers for Medicare & Medicaid Services anticipates national healthcare expenditures to grow to $5.7 trillion by 2026. With this growth, healthcare real estate, specifically medical office buildings, are poised for further success.

Medical Office Buildings

Medical office buildings comprise approximately 10% percent of the US office sector. These buildings are typically about 40,000 square feet and range from small physician offices to large healthcare systems. Investors are attracted to this asset class due to its stability and positive forecasts for a strong performance. On the rise for the last four years, medical office sales totaled $10.4 billion in 2018.

“Medical office buildings are so popular and are in demand as a renovation or as new construction,” says Jason Signor, CEO and partner of Caddis Healthcare Real Estate. “The market is phenomenal and occupancy levels and rental rates are healthy.”

It is well-known that the the aging US population is directly correlated with the rising demand for healthcare as doctor visits dramatically increase with age. Individuals 65 years and older spend five times more on healthcare than those who are younger. Yet, even with the favorable demographic and economic backdrop, new healthcare construction has not kept up with demand.

“With the continued shift from inpatient to outpatient care, new real estate strategies are being implemented which includes moving to urgent care centers, MOBs, micro-hospitals and health-system sponsored wellness centers,” says Signor. “ Outpatient care is booming and will continue to flourish in the future. The challenge, of course, is for our sector to keep up with the growing demand.”

Ambulatory Surgery Centers

Ambulatory surgery centers—healthcare facilities which offer patients the option of having procedures and surgeries performed outside of the hospital setting—have drastically reduced healthcare costs. According to the American Hospital Association, the number of ASCs and hospitals are almost equal with 5,534 hospitals and 5,532 surgery centers. While hospitals have declined by 5%, surgery centers have grown as much as 82% since 2000.

“ASCs will continue to dominate the healthcare real estate landscape,” says Signor. “We won’t see these large hospital campuses being built as much. As the campuses get older however, you will see more renovations as hospitals keep up with medical technological advances and stay abreast with ASCs.”

 

Source: GlobeSt.

Medical Office Buildings Still Rule The Outpatient Space In Healthcare Real Estate

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Of the five main outpatient facility types, medical office buildings (MOBs), urgent care centers and ambulatory surgery centers (ASCs) have the most positive outlooks and futures in the healthcare and healthcare real estate (HRE) sector.

On the other hand, the outlook is not quite as positive for micro-hospitals, which have a “moderate” outlook, and freestanding emergency departments (FEDs), which have a “negative” outlook. That’s according to a scorecard, if you will, compiled by well-known healthcare research and consulting firm The Advisory Board Co., which is based in Washington, D.C., and is part of Eden Prairie, Minn.-based Optum.

Providing insights into The Advisory Board’s rankings and outlooks for the various outpatient property types was the company’s Fred Bayon, managing director. He did so during a 100-minute presentation that covered a wide range of topics affecting the healthcare sector during The Colliers National Healthcare Conference, held Sept. 12-13 at the Hyatt Centric Chicago Magnificent Mile.

“My job with The Advisory Board is to travel around the country and meet with our members … hospitals and health systems, C-suite executives and the health system boards of directors and let them know what’s happening in the healthcare market place, what they need to be strategizing about and be aware of concerning healthcare policies and healthcare changes and issues,” Mr. Bayon told the audience.

Near the end of his presentation, which included plenty of insight into current healthcare policy and disruptors to the status quo, Mr. Bayon gave the firm’s outlook on the various property types.

As has been the case for several years, The Advisory Board is most optimistic about the short- and long-term prospects for MOBs. The rise of MOB development and investment has occurred in large part because they allow hospitals and health systems the best and most economical way to enter new markets, to protect market share, to provide convenient access to patients and to help facilitate the coordination of care.

“The MOB market continues to be a positive, intriguing play for hospitals, health systems and investors,” Mr. Bayon told the audience. “Those players are and will remain interested in MOBs for years to come because they “are conveniently located, essentially for Medicare patients and commercially insured patients. Health systems do not want their patients to have to come downtown, they don’t want you to come into the maze that is the big hospital campus. Instead, they want you to go somewhere where there is parking and where there is a pleasant atmosphere, because that’s where they think they can drive volumes.”

The Advisory Board gives its next highest ranking to ASCs — which, even though they carry some risk because of the lower-profit margins they deliver — will continue to experience increased volumes in years to come, he said.

Mr. Bayon noted that volumes in ASCs are expected to increase by nearly 28 percent by the year 2027, driven in large part by ongoing policy changes by the Centers for Medicare and Medicaid (CMS) that will “reimburse Medicare procedures done in ASCs. For example, total knee (replacement) and some cardiac procedures” have recently been added to the list of procedures that, when done in ASCs, will be reimbursed by Medicare.

Also receiving a positive score, or outlook, from The Advisory Board are urgent care centers, which the firm is “pretty bullish on,” Mr. Bayon said.

“More and more health systems are looking at urgent care centers and having some sort of investment in them, or some sort of partnership in sites across the United States,” Mr. Baynon said. “We still see these growing rather rapidly and for us, this is becoming a primary care alternative that can alleviate some of the capacity crunch for primary care in some markets.”

Even though The Advisory Board is not as bullish on FEDs and micro-hospitals, Mr. Bayon noted that the firm is “neutral” on the facility type, as those that are placed in the right locations can provide benefits for health systems, especially when they are expanding into new markets.

“Micro hospitals, the eight- to 12-bed hospitals can help a system bring together some inpatient and outpatient services, with core services being acute care, emergency care, pharmacy and additional services,” Mr. Bayon said. “(Micro-hospitals) continue to be a big, big play in the Texas marketplace, but we can see this growing in other markets as well. What’s interesting about micro-hospitals for developers and healthcare providers is that these facilities are not subject to site-neutral payments, meaning they can bill at inpatient rates and then they can generate their own on-campus or off-campus definition, meaning they can put outpatient services within 250 yards of those micro-hospitals and not be subject to a site neutral rate. For us, I would say that right now we are pretty neutral on micro-hospitals.”

The Advisory Board gives its lowest ranking, or outlook, to FEDs, which, in some instances,

“One of the things to keep in mind is that government payers do not reimburse freestanding emergency departments, but they are dotted across the United States and there are some hospital systems that believe such facilities are something around which they can build more services over the longer term,” Mr. Banyon said.

The Advisory Board, however, has a negative outlook on the facility type in large part because “they could drive unnecessary utilization if we see a preponderance of them.

“And I think that CMS could look at decreased reimbursement to FEDs moving forward,” Mr. Banyon continued, “and this is not to distinguish between an ED in a hospital setting and a freestanding setting. That’s a big risk for health systems.”

 

Source: HREI

Healthcare Trust Of America: The Best Way To Play Healthcare Trends

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While there is no question the demand outlook looks robust, the supply side of the equation remains a rough one for many property types.

Does that make many healthcare REITs uninvestable? No, but it could never justify pulling the trigger at current valuations.

When it comes to medical office buildings, however, there is a defensible moat here on an operational level and just as many, if not more, of the trends in healthcare benefit the industry. As the largest and most pure play on these assets, Healthcare Trust of America (HTA) trades at a clear discount to its intrinsic value. While not a home run type of purchase today, hitting singles and doubles never hurt anyone.

Overview of Healthcare, Medical Office Building Outlook

Everyone knows the bull thesis for healthcare. The Office of the Actuary for the Centers for Medicare and Medicaid Services (“CMS”) recently projected that national health spending will rise 5.5% annually from 2018 to 2027. That means that, once again, healthcare spend will outstrip likely GDP growth for the next ten years. Within the “buckets” of healthcare spend, no matter the category (hospital care, physicians, prescription drugs, nursing) cost inflation is on the rise.

Part of that is economic (inflation, higher wages, more demand) and part of that is demographic (Baby Boomers). No question that healthcare is and will be one of the fastest growing areas of the market. Who or what captures the economic value from that growth has profound implications across the industry, real estate included.

Investors will not find a healthcare REIT not citing rising spend and aging demographics as a bull catalyst. However, there is criticism of the supply side of the equation in recent years, including bearish calls on plays like New Senior (SNR), Ventas (VTR), or some skilled/assisted nursing home operators themselves like Senior Care Centers. Depending on the asset type, there is often very few barriers to entry – particularly in the senior housing whether it be skilled nursing or assisted living. As much as the industry tries to talk about “viable infill” opportunities in certain markets, even strong locales eventually reach operational parity as competition moves in. Bad markets just cannot be fixed.

Medical office buildings (“MOBs”) are an exception. Unlike other areas of the healthcare real estate market, there are actual barriers to entry. Location matters. On-campus and near-site off campus buildings within high demand medical areas have seen immense value growth. Cap rates have contracted by 400bps since the Great Recession and steadily improved even in recent years which is slightly unusual. All else equal, that implies a 70% increase of property values even on flat net operating income (“NOI”). In actuality, comps have been healthy (low to mid single digits) which has created riches for owners which often has been the hospitals and health systems themselves.

These assets also benefit from a litany of trends in the American healthcare system, the most important of these is the increasing move towards outpatient services. Readers already know procedures are just nutty expensive nowadays. The only way for service providers to somewhat constrain costs is by reducing patient time spent under medical care. Avoiding an overnight hospital stay can save thousands of dollars per patient, often without any change in complication or readmission rates. Insurers are more than willing to allow hospitals to capture higher incremental profits to encourage outpatient work. MOBs, by their nature, rent to tenants providing these kinds of procedures.

As the entire healthcare industry continues to consolidate, health systems will inevitably target expansion within the core areas of their network. Heavy capital investment and infrastructure build-out leads to adjacent MOBs seeing growth. Hospitals, who still remain the majority owners of MOBs, are also highly incentivized to sell. Whenever a hospital is the landlord and rents space to physicians, they run greater risk of violating the Anti-Kickback Statute which bans any type of payment for referrals. Selling to a REIT like Healthcare Trust of America frees up capital while also avoiding any potential allegations of favorable rent treatment.

Healthcare Trust of America

MOBs are the Healthcare Trust of America bread and butter. Nearly the entire portfolio (94% of gross leasable area) is in this type of asset. The company owns 23.2mm square feet, making it the largest publicly-traded pure play in this space. Assets owned are primarily located in major metropolitan markets like Dallas, Houston, Atlanta, and Boston. This has taken quite a bit of hard work and time. Operating a bit under the radar, management has been high-grading the locations of its assets over the past five years. Acquisitions have leaned towards more dense urban areas and there has been some decent efforts made in cutting underperforming properties, including $300mm worth of dispositions last year alone.

While major healthcare REIT players like Welltower (WELL) and Ventas (VTR) have significant MOB portfolios, it isn’t their primary business. On a comparable basis, Healthcare Trust of America has spent more acquiring and developing in this space than anyone else. It shows through the results. Funds from operations (“FFO”) per share has grown at a 5.2% clip since 2014, outstripping the peer group significantly which has struggled to see any material change. The largest contributor to that has been same store sales growth which has run well above average.

Management is very efficient with its capital spend, runs a solid investment grade balance sheet with lower than average leverage, and has still managed to outgrow comps. No wonder shareholder returns have eclipsed other healthcare players as well – and I’d argue that as far as the stock price goes it should have done better.

CEO Scott Peters believes the business can generate substantially similar FFO growth going forward to the rates it has earned in the past. Contributing factors to that remain the same: low single digit same store revenue growth, marginal annual expense savings, and a touch of occupancy rate improvement. The expense growth target an admirable one in particular. Unlike many other REITs in this sector, same store expenses has actually shrunk over the past few years as the portfolio has grown, something most REITs do not accomplish. Tie the cost focus together with acquisition and development and management believes that execution can deliver 8-12% annual shareholder return potential even assuming no multiple contraction over the medium term. This does not rely on further cap rate compression which could also boost the market’s outlook.

Takeaways

Is the dividend exciting? No, 4.5% isn’t anything to write home about. Is this a deep value opportunity or something that might make you rich overnight? No, this is not one of my usual deep value contrarian plays. Is it an investment grade player with long term contracted cash flows, making a dividend cut is incredibly remote? That it is. Using my usual REIT framework, does it trade at a discount to net asset value (“NAV”)? Arguably, yes. With projected $450mm in 2019 NOI and valuing the business at a conservative 5% cap rate, there is about 15% upside to reach NAV.

Not every investment needs to have 30, 50, or 100% projected upside to make sense. This one just works. Investors have seen quite a lot of dividend cuts over the past year.

 

Source: Seeking Alpha