Houston Medical Office Construction Is Growing, But That Won’t End The Supply Squeeze

Houston is home to the Texas Medical Center and scores of hospitals. The strength of the local healthcare industry has supported the city’s medical office market, which enjoys a relatively low vacancy rate and an expanding pipeline of new product under construction.

But the majority of buildings underway are heavily pre-leased or owned by a specific hospital system, according to brokers, meaning the market will essentially remain the same when it comes to vacancy and absorption levels.

In other words, supply is expected to remain tight for the foreseeable future. And that could pose a problem for healthcare providers looking for swift expansion options while boosting rents in the long term as land and construction prices continue to rise.

“Most of it's going to be occupied the day it's finished,” Colliers International Senior Vice President Coy Davidson said.

Houston has around 42.2M SF of existing medical office space. Another 1.9M SF was under construction as of Q2 2021, surpassed only by Chicago for the most square footage on the way nationally, according to Colliers International’s 2021 Mid-Year Houston Healthcare Market Report.

That pipeline has been growing over the past few quarters as developers and owners opted to restart their construction pipelines. Industry experts said earlier this year the healthcare sector is experiencing a construction surge that has also meant dealing with subcontractor shortages, material delays and rising costs. 

Normally, a growing pipeline of square footage under construction might raise concerns about future vacancy and absorption rates. But that’s not the case for Houston’s MOB market. Right now, the construction pipeline is mostly made up of space that has been pre-leased, typically belonging to a hospital system.

Some examples of Houston-area MOBs underway include Baylor St. Luke’s Medical Center’s 12-story, $426M O’Quinn Medical Tower and Texas Children’s Hospital’s $201M expansion of their Texas Children’s Pavilion for Women — both in the Texas Medical Center.

“I don't see [the new construction] affecting anything much at all,” Davidson said. “We've kind of stuck around between 10% and 12%, 13% vacancy in the medical office market for years. We're not really adding a crazy amount of new square footage.” 

Speculative MOB projects like the 10-story, 364K SF Museo Medical Office Building in the Museum District are considered rare. That’s because MOB projects tend to be more expensive as well as riskier for developers, according to Transwestern Executive Vice President, Healthcare Advisory Services Justin Brasell.

“Everybody that I talk with, all of our clients still want to see some pre-leasing,” Brasell said.

The general rule of thumb is to pre-lease at least 50% of a MOB before moving ahead with construction, according to Brasell. That figure isn’t fixed, and the largest hospital systems may serve as an exception, anticipating that they will end up leasing space to affiliated physicians.

Medical office can sometimes be conflated with life sciences, but the two products serve very different tenants. While MOBs are designed to cater to physicians and patients, life sciences are typically focused on healthcare tenants performing research and development activity. 

Several major life sciences developments are underway in Houston, including TMC3, which is owned by the Texas Medical Center; Rice University’s The Ion project; Hines and 2ML Real Estate Interests’ Levit Green; and Medistar Corp.’s Innovation Tower, as well as the forthcoming Texas A&M Innovation Plaza development, which will include medical office and lab space within its Horizon Tower.

Despite millions of square feet dedicated to life sciences under construction, that product is unlikely to affect the supply dynamics of the MOB market, Brasell said.

Reflecting the tightness of the market, Houston MOB sales have been sluggish this year. Colliers International found that 10 MOBs totaling 380.8K SF sold during the first half of 2021, significantly less than historical volumes. Davidson pointed to a lack of inventory as the main problem. 

“There's just not that much on the market. And there's a lot of people looking for medical office assets, but there's just not that many to buy,” Davidson said.

The tight supply has helped boost average asking rents. Citywide, rents averaged $22.68 per SF in Q2 2021, up from $22.22 per SF a year ago. Prices for Class-A buildings in well-situated locations can be much higher, but, overall, the expectation is that MOB rents will continue to rise.

Investor enthusiasm for MOBs has been growing for years, alongside other alternative commercial real estate assets like self-storage and student housing. Brasell said he has received at least three calls a week for the past five years from investors looking for opportunities. 

“There's a supply and demand disconnect in that there is so much more money chasing medical office than ever before and there's just not enough product,” Brasell said.

Houston’s regular office market had a vacancy rate of 23% during Q2 2021, according to a Colliers International office report. It is one of the highest office vacancy rates in the country, reflecting a historic tendency to overbuild during oil booms. Davidson said that MOBs have never had that problem, which makes them a less risky asset type. 

Because there’s so much vacant regular office space in Houston, it raises the question of whether owners should consider trying to convert their assets into MOBs. But converting office into space for clinical use is not an easy task.

MOBs primarily cater to physicians and patients, meaning that they need more plumbing and electricity access than a normal office building, as well as advanced HVAC systems. Another differentiator is square footage — ideal MOBs range between 25K SF and 100K SF.

“The chances of you leasing a medical building of 500K SF is slim to none because, typically, the tenant size for healthcare is a lot smaller than office,” Brasell said. 

Transwestern has some experience in converting regular office to MOB. The firm purchased a three-story, Class-A, 114.4K SF office building at 2051 Greenhouse Road in west Houston in 2018 and spent nine months converting it. Overall, the conversion cost around $400K. 

Brasell said the building was a good fit for several reasons. It had originally been envisioned for energy users and it delivered in 2014 — right when oil prices crashed. As a result, the property only had a handful of existing tenants on the top floor, making it relatively straightforward to convert and rebrand the building as an MOB.

2051 Greenhouse Road, now called Greenhouse Medical Plaza, is also located across the road from Houston Methodist West Hospital and Texas Children’s Hospital West Campus. That proximity to two major hospitals is crucial, as it provides strong incentive for healthcare tenants to consider leasing space in the building.

Rebranding and repositioning an MOB in the market can also take some time. Brasell noted that while the physical conversion of 2051 Greenhouse Road took nine months, it took even longer to educate the market that it was now an MOB.

Transwestern was tapped in November to provide leasing and management services to 6500 West Loop South, a five-story, 390K SF building in the Bellaire submarket. That property is in the process of being converted to an MOB, despite being larger than a typical MOB asset. 

Brasell said UT Physicians will be consolidating several offices into that location, and that Transwestern will be looking for tenants of 20K SF or larger. Very few healthcare tenants operate at that size, but the goal is to cater to large hospital or healthcare systems opting to move support operations out of the Texas Medical Center to a lower-cost location.

“Right now, there are no large contiguous blocks of space in Bellaire. So we're kind of at a really good competitive advantage,” Brasell said.