Paula Hess is a former editor of California Real Estate Magazine and a Los Angeles–based freelance writer.
Health Care’s Growing Real Estate Footprint
Demographics and need for convenience boost demand for non-traditional spaces. What makes for successful transactions?
November - December
For all of the complexities of America’s health care system, one thing that’s gotten easier for consumers is finding a health professional nearby and on short notice—even in the evening or on weekends. Check-ups, minor illnesses, and vaccinations can now be handled at supermarkets, pharmacies, and other retail outlets, while standalone urgent care and outpatient surgery centers are cropping up in neighborhoods where people live and shop. In a nod to the trend, gargantuan hospital systems are opening compact outposts closer to their patients.
- Medical office building vacancies: 2018’s national vacancy rate of 8.2 percent was virtually unchanged from 2017’s all-time low.
- Cap rates: 6.7 percent.
- Average asking rent: Approximately $23.50 per square foot in Q4 2018.
- Source: Colliers International 2019 Healthcare Marketplace Report
“Health care is coming to the patient, rather than the patient traveling to the health care provider. It’s all about ensuring a convenient location and positive experience,” says Paul Wexler, founder of Wexler Healthcare Properties at the Corcoran Group in New York. A 2018 CBRE report found the number of outpatient clinics had increased 51% between 2005 and 2016 to 26,863.
There are many reasons behind the proliferation of medical facilities. Demographics, technology, and the Affordable Care Act have created “seismic change,” says Wexler. The two largest demographic groups, the boomers and the millennials, both covet convenience, though their health care needs are vastly different. As a result, he says, hospitals are shifting their focus from building more hospitals to providing care outside their main complex.
Wexler’s group recently leased 68,000 square feet to Manhattan’s Hospital for Special Surgery to build a state-of-the-art ambulatory surgery center and diagnostic center on the opposite side of the city from the hospital’s main site. “This is a great benefit for consumers who do not want to commute to different facilities for health care services,” said Wexler, a real estate professional with 34 years’ experience in the health care real estate sphere.
In the past, a typical doctor’s office was 1,000 to 2,000 square feet; today a standard health care space ranges from 3,000 square feet to more than 8,000 square feet, Wexler notes. These spaces may accommodate primary care, pharmacy, ambulatory surgery, and subspecialties in a one-stop experience.
More compact medical equipment, the emergence of virtual care, and ACA mandates requiring cost-effective care are further accelerating the migration of services away from hospitals. Consequently, Wexler notes, traditional health care systems and groups are reevaluating their space, either consolidating, selling off, or repurposing new properties—a trend that should continue regardless of what happens with the affordable care law.
Build, Buy, or Lease
“Hospitals are ‘spoking’ out into retail and other commercial locations,” says David Wilson, CCIM, immediate past president of CCIM Institute and current vice president of real estate development at Ryan Companies in Davenport, Iowa. “Everyone is striving for the Walgreen’s model. Clinics want to be on a hard corner,” an intersection with frontage on two sides, observes Wilson. The cost to buy or lease a hard corner is usually cost-prohibitive for physicians and physician practices, he explains, but hospital systems and clinics desire that high-profile location to market their systems.
The decision to build, buy, or lease hinges on operational expenses. Can they afford to build, which is usually the most costly option? Is a lease more desirable because the location is a temporary, entry-level site in anticipation of future expansion to another location? Wilson notes that medical office building construction costs vary depending on finishes and requirements, such as lead-based walls, but typically are not less than $200 per square foot ($150 per square foot for shell condition and a landlord contribution of roughly an additional $50 per square foot for tenant improvements).
A Minneapolis-based full-service health care real estate firm called Davis operates in nine states and assists hospital systems and independent clinics with strategic planning: identifying patient demographics, competitors, gaps in market coverage, and future coverage areas. Large health care systems want to own core real estate on a hospital campus so they can control the space, occupancy, and what services are provided in the adjacent medical office building, explains Davis principal Jill Rasmussen, CCIM, SIOR. But she notes, “Health care systems and clinics have so many capital needs—labor costs and expanding care—the last thing they generally want to do is spend capital constructing and owning a building.”
- Most medical office leases range from 10 to 15 years.
- Most leases have a low base rent: The landlord leases a space to the tenant in a shell condition with a tenant improvement package on a per-square-foot basis.
- The landlord makes improvements and turns it over to the tenant in turnkey condition. Improvements are amortized into the base rent, making the rental rate higher.
- Most landlords include a Consumer Pricing Index inflation indicator in the lease and rent increases annually.
To overcome that hurdle, some health care systems have issued bonds or turned to credit tenant lease arrangements, reports Becker’s Hospital Review. Thus, Davis’ ability to bring capital to the table is a big plus. Davis’ projects, which can span two to seven years, run the gamut from building a joint venture 10,000-square-foot specialty dental development to building a 150,000-square-foot, full-service specialty center for a large health care system in the Twin Cities. The latter project encompassed a surgery center, imaging, primary care, and specialty and urgent care. Independent clinics also signed leases that included urology, dermatology, and OB-GYN services.
Typically, projects are in the 40,000- to 50,000-square-foot range, Rasmussen notes, with a hospital or clinic anchoring a development and Davis leasing the project with additional clinics to create good referral synergy within the building. “Sometimes the large hospital system will timeshare out a portion of its space to specialists so they can offer those services within their primary care clinic,” Rasmussen says.
Younger physicians typically seek out lease arrangements, but older and established physicians are better positioned to purchase the space where they practice, notes Wilson. “They want an asset they can sell with their practices,” he adds, “so many choose to purchase and repurpose.” Bigger medical groups, such as orthopedic practices, are taking box spaces and converting them into clinics. In these cases, the landlord makes improvements and turns the property over to the tenant in turnkey condition. These upgrades would be amortized into the base rent, which makes the rental rate higher.
Davis has advised on a retrofit of an Old Country Buffet for a big hospital system and has retrofitted a Wick’s, a Blockbuster Video, a Gander Mountain, and a Borders Books. The appeal is location: Big box retailers have done the market research to identify prime space. But Rasmussen cautions that the cost of retrofitting—lowering ceilings, core drilling, and updating for medical use—can “be more challenging and not as cost-effective as you would think.”
Traditional retail spaces can also be a challenge she says. Retail property owners are often putting together a mix of tenants with shorter-term leases and not providing money for tenant improvements. “Clinics need long-term leases because of the capital it takes to build the spaces; they also need high tenant improvement allowances.
One novel workaround that has enabled a healthcare group to migrate into a retail space is Kaiser Permanente’s partnership with Target. As part of the arrangement, Kaiser Permanente physicians staff Target store clinics in California seven days a week, extending the brand into a retail sector.
RJ Przebinda, broker-owner of Gold Leaf Group Healthcare Real Estate in Pasadena, Calif., is an advocate and tenant representative for clinicians, most of whom are first-time practice owners. His business specializes in dental and physician offices and small urgent care and surgery center leases, closing 15 to 20 deals annually. He echoes Wilson’s observation that many young physicians and dentists haven’t amassed the wealth needed to purchase properties.
Clients looking to purchase commercial real estate for their medical practices generally use Small Business Administration financing, he says, which requires occupancy of 51% of the space. Often, they’re competing with well-capitalized retail or restaurant entities also looking for visible, “well-parked” locations. So leasing may be the only option.
Przebinda leveraged experience reviewing leases for a large retailer to establish his health care real estate practice. His transactions—typically two or three clinicians seeking practice space—require properties that are compact and visible with ample parking, as well as close to the hospital where the physicians have privileges. These constraints often require that Przebinda’s clients build out from scratch or repurpose former restaurants, banks, framing stores, or clothing stores. He estimates that only 10% to 15% of the spaces he’s secured for clients were formerly medical office space.
Zoning issues are not as daunting as many medical tenants fear. “There is a misconception that zoning changes are required to change commercial space to medical space,” Przebinda says. “Almost always, if a space is zoned commercial, it is also zoned for medical,” he says. The main issue, especially in automobile-centric Southern California, is whether a property is both zoned and “parked” for medical use.
As health care systems and clinicians continue to seek ways to move closer to their patients and provide quality care, it’s important for real estate professionals to view this migration not as a series of one-off deals but instead as a long-term industry strategy. “It’s really helpful for these groups to have a knowledgeable health care real estate adviser with a deep understanding of the industry and the business,” says Rasmussen. This approach will help health care providers make better real estate decisions and understand how real estate can help with their planning and meeting their financial objectives.