Even Reliable Medical Office Market Is Pulling Some Sick Days

If the third time really is the charm, that’s news to Jon Boyajian. The Echo Real Estate Capital principal had to call 39 banks to get funding for an Indiana medical office asset the group acquired, underscoring how challenging the current environment is to secure medical office financing. 

Headwinds are as sharp for medical office as any other asset class these days. And while industry players remain optimistic about its performance and potential compared to traditional office and other CRE problem children, it is still getting tougher out there, according to panelists at Bisnow's Chicago Healthcare Summit Sept. 26 at the Mag Mile Medical Pavilion.

With financing hard to come by, the historically stable medical sector has seen transaction volume fall sharply. Tougher margins are bumping rents higher and convincing more developers and occupiers their best bet now is renovating older properties, not taking on new ones.

As for Boyajian’s Indiana deal, he ended up getting financing from a local credit union that was familiar with the property. But that wasn’t as easy as it once was.

“I really had to scrape the barrel to get even three term sheets,” Boyajian said. “So [it’s] certainly a challenging environment from a bank lending standpoint.”

RX Health & Science Trust Chief Investment Officer Jesse Ostrow said debt across all asset classes is harder to attain, which is leading to lower transaction volumes. 

Year-to-date sales volume for medical office centers is down about 62%, with the average deal year-to-date in 2023 ringing in at about $9.6M, per CBRE data reported by GlobeSt. Smaller deals are still being completed, but larger transactions have slowed considerably, CBRE’s Chris Bodnar, vice chair and head of healthcare advisory, Americas, told GlobeSt. 

The issue isn’t less demand — the necessary nature of medical office visits and an aging population ensure plenty of that — but the limited availability of debt at higher price points. As a result, cap rates for medical office centers rose to an average 7.1% last quarter, Bodnar said, the highest they’ve been in the last seven years.

To distance itself from other asset classes in the financing environment, Ostrow said the industry is changing the way it refers to itself, pushing the term “medical outpatient facilities” over medical office. He jokes with some of the trust’s lenders to refrain from billing properties as medical office because they then get lumped in with traditional office assets in the eyes of loan committees. 

The slowdown in financing and transactions has led property owners to either increase margins through rent hikes or by renovating existing spaces, panelists said. 

Boyajian said his company has negotiated rent increases because of how hard it is for tenants to move out of the buildings they occupy. Medical practices generally don’t want to go through the hassle of conducting a search for a new facility, physically making the move, and disrupting their operations and patients, he said.

“When you put all that into the soup, it's easier just to re-sign your lease,” Boyajian said. “For that reason, we're still very bullish on healthcare.”

Ostrow said a lot of providers and health systems have struggled with high labor costs, which is part and parcel of the broader labor shortage. As a result, RX Health & Science Trust is focused on controlling the occupancy costs of the buildings it owns, develops or manages more closely than it did in the past. 

The trust is also buying existing products and renovating others instead of constructing new properties because those strategies cost less and move more quickly. Citing an industry report, Ostrow said the cost of new builds has gone up from $392 a SF last year to $492 a SF now, which makes it harder to justify new construction costs.

“[Tenants] really have to want to be in a brand-new building and wait a couple of years to move into that building,” Ostrow said. “So for the time being, the most cost-efficient solution for a provider from a real estate perspective is to stay in an existing building or move into an improved building.”

Some renovations are being driven by technology considerations.

Mortenson Healthcare Development Executive Maggie Beckley stressed the importance of designing physical spaces that include room for telemedicine capabilities. These spaces need to have the ability to transmit lots of data and provide a private space for teleconferencing.

“There's this misconception that the role of telemedicine will reduce the need for physical space, and that's not the case,” Beckley said. “We'll always need physical facilities to provide care, but what it is, is reducing the demand for traditional exam room space. So we have to think about being flexible in the way that we design our facilities.” 

As far as the outlook on future healthcare development in the region, sentiment was mixed. Ostrow said he still believes medical office is “as healthy as it’s ever been,” citing high occupancy rates, strong absorption figures and increasing net operating income. 

But high interest rates will continue to dampen the number of new buildings going up, he said. 

“As long as rates stay high, [development is] going to be lower than most people in this room want,” Ostrow said. “We're focused on redevelopment of existing facilities, which I think will increase. So if you define development as also including redevelopment, I think it's going to be significant. But if you classify development as ground-up, brand-new facilities, it's probably not going to be as robust as it was.” 

Even so, investor interest is unlikely to dissipate. Despite rising rates and limited lending, a spring Cushman & Wakefield medical office building report predicted that investors would continue to be drawn by MOB’s resiliency compared to other asset types, forecasting “a growth in transaction activity when debt and equity markets feel comfortable enough to reinitiate acquisitions.”

Hammes Partners principal Justin Shea echoed the report’s positivity about the direction of the asset class. 

“There's much more institutional money trying to get into the space because … other asset classes are not performing as well, and healthcare continues to really lead the way,” Shea said. “It's proven to do that over a number of different cycles over the past 20 to 30 years.”