By David Lynn
Over the last ten years, medical real estate has been one of the best performing real estate sectors during the peak and through economic cycles, backed by the robust growth of the medical industry, which is now the largest sector of the U.S. economy.
Medical real estate offers a combination of growth, income, long-term returns, safety and low volatility. Strong macro tailwinds, robust property fundamentals, high current income and total returns, low volatility and correlations, make it a compelling addition to institutional as well as retail investors’ investment portfolios.
Focusing on a particular type of medical real estate investment -- the Medical Office Building – it has been the main vehicle for outpatient healthcare delivery in the U.S. for over the past 30 years. The medical industry has transformed itself from predominantly hospital and in-patient care to mainly MOB and outpatient care. In fact, over 70 percent of all healthcare service delivery (including the majority of surgeries) is on an outpatient basis. This transformation is leading the industry activities and is driven by the trends and factors that will be illustrated in detail in the following sections.
The main trends and factors underlying the continued strong growth of medical real estate include: changing demographics, the healthcare regulatory environment, technology advancements, robust demand and supply fundamentals and attractive investment attributes.
A rapidly aging population and increasing longevity play a key role in the expanding demand for medical real estate.
Population growth in the 65+ year-old category is expected to remain the highest among all age groups through at least 2060, with particularly strong growth during the next 15 years. Through 2030, the 65+ population is projected to increase by more than 50 percent, or by 25 million people, to account for more than 20 percent of the U.S. population, according to the U.S. Census Bureau. Americans are also living longer - based on research by the Society of Actuaries, a 65-year-old female has a more than 40 percent chance of living to at least the age of 90. Aging generation has a dramatic effect in increasing healthcare demand over the next several decades.
THE HEALTHCARE REGULATORY ENVIRONMENT – TODAY AND TOMORROW
Today’s U.S. healthcare industry is restructuring, driven by regulatory reform and capital market dynamics. As we focus on Obamacare or the ACA (Affordable Care Act), we can see its regulatory context and driving power in the healthcare industry.
Although the current administration has stated its position of partially repealing the Patient Protection and Affordable Care Act of 2010 (ACA), it will be a prolonged process that will likely play out over multiple years. Certain healthcare trends are here to stay, regardless of the ACA, such as the migration to low cost consumer-driven healthcare (CDHC) and value-based delivery systems, which is propelled by improving patient outcomes at a lower effective cost.
Providers who respond successfully to these trends and are able to deliver quality care at lower cost are likely to benefit financially. Certain initiatives even taken under the regulatory uncertainty, but having long term prospect, is pinpointed.
Value based models and reimbursement incentives will shift even more inpatient volumes to outpatient settings. Outpatient services as a percentage of hospital system gross revenues have increased to 65% in 2014 from 35% in 2005. Moreover, today more than 70% of all Americans receive their healthcare on an outpatient-basis model.
Consumer-driven healthcare (CDHC) leads to proactive and preventive health care approaches which will be performed in various settings outside the traditional hospital or clinics and with the technology advancement.
As a result of increased regulatory uncertainty, consolidation will continue across the entire healthcare sector through both traditional M&A as well as joint ventures and partnerships.
The advance in medical science as well as Information Technology that has been increasingly integrated into medical care is playing a significant role in greater patient health awareness and treatments.
Medical technology has not only enabled thousands of new diseases, conditions and afflictions that were unknown and undiagnosed, to be addressed and treated, but more importantly to personalize treatment. Precise and real time biometric-driven medicine is a new paradigm that requires technologies to capture, aggregate and analyze massive volumes of genomic data. This could particularly create a revolution in “specialized medicine” that pushes medical demand even higher. Although aggregating and maintaining a longitudinal personal medical record across multiple care settings remains a significant challenge, quality care provided in multiple outpatient settings is becoming mandated in order to respond to value-based reimbursement programs and it requires timely data without compromising security and accuracy. The latter will have to be addressed technically. The advancements in consumer products, such as Fitbit, are also promoting the paradigm of personalized medicine.
The technology development in medical science, IT and consumer product are changing the landscape of healthcare delivery. Outpatient clinic as an important components of such, will be bolstered by rapid technological advancements.
ROBUST DEMAND AND SUPPLY FUNDAMENTALS
The high barrier to entry has largely limited speculative development of MOBs which leads to few oversupplied markets. Initially due to the recession, but since hindered by uncertainty surrounding the ACA, medical office building development has declined by 60 percent comparing to 2008, according to a report by Marcus & Millichap Research. The uncertainty in many aspects of the market has slowed down the medical tenants’ decisions on new MOB spaces. We expect that the completions will remain well below the prior cycle’s averages in 2017. At the end of the third quarter of 2016, MOB space under construction totaled 18.4 million square-feet or only 1.4 percent of the total stock, according to CBRE.
On the demand side of the equation, even with the near term regulatory uncertainty, demand is strong. In 2015, the United States spent more than $3.1 trillion on healthcare. Between 2014 and 2024, employment in healthcare sector is projected to grow over 20 percent, generating 3.8 million new jobs —more than any other industry in the U.S., according to the Bureau of Labor Statistics.
Medical office building occupancy exhibited very low volatility during the recent 2008-2012 recession, in contrast to traditional office space occupancy which fluctuated and stabilized at much lower rates, according to Marcus & Millichap Research. The medical office market continued to tighten through mid-2016, when the vacancy rate dipped below 10 percent for the first time since the start of the recession. It is important to note that the Class A and B MOBs, of age 20 years or less, have a vacancy rate of only 4 percent nationwide, according to Marcus & Millichap Research.
The divergent growth trend of supply and demand will remain unabated in the current market and exert impact on the mid-to-long term market fundamentals.
ATTRACTIVE INVESTMENT ATTRIBUTES
As an emerging sector, the risk-return profile and long term healthy prospects of medical real estate have drawn both institutional and retail investors. Capital has surged in over the last several years, driving down cap rates by 130 BSP in 5 years with current cap rates hovering between 6.0 and 6.5, according to Costar. Private equity firms as a relatively new investor group have been running at $5 billion a year in acquisitions, a five-fold increase. They also tend to extend the holding period beyond the customary seven years.
Being a new asset class, MOB attracts investors for its following attributes including: being a recession resistant asset class, having strong tenant retention, providing stable cash flow, reinforcing tenant credit enhancement and backed by active market transaction.
Medical office buildings are the most defensive sector of healthcare real estate, with long term net leases, healthy annual rent increases and robust risk-return profiles. Overall, both tenant and investor demand for MOBs may be expected to remain solid in 2017.
A robust growth of the MOB market is anticipated for the foreseeable future. Demographic trends will support continuing demand for the next two decades, driving up health care employment. Technology advancements and health oriented lifestyle is revolutionizing the way healthcare is delivered. Healthcare policy is evolving to correlate with social and economic development - uncertainty is expected for the near term, but certain trends are here to stay and going to define the future of healthcare. Despite all the moving parts in the dynamic healthcare industry, the ongoing expansion of the economy will fuel the healthcare revolution with booming demand. Positive macroeconomic outlook and demographic trends will continue to attract investors to the sector, and medical offices will stand out as a unique and leading sector in the gamut of real estate asset classes.
(Editor’s Note: May vary slightly as published.)