Category: Principal Perspective

No question. The cost structure for new outpatient medical space has reached unprecedented heights. High interest rates, a tight labor market, supply chain issues, and record inflation have all contributed to the cost of new outpatient medical space crossing the $35 per square foot threshold and in some instances approaching $40 per square foot.  When confronted with this reality, many physician groups have elected to forego growth opportunities and/or put off relocation to upgraded/expanded space.  The status quo may help manage the expense side of the ledger but does not facilitate revenue growth.

In past cycles, low interest rates helped to negate the impact of rising construction costs. No such luck in the current cycle. From 2022 to 2024, construction costs increased by nearly 25 percent. As for interest rates, the Federal Funds Interest Rate went from 3.25% in September 2022 up to 5.5 to August of 2024 (it was recently cut to 5%). Given the reduced amount of construction demand, contractors have reduced their profit margins to stimulate business. 

While rental rates and development costs will not soon, if ever, return to the pre-pandemic baseline, the next 12-18 months should offer some relief and a degree of stability that the market has not enjoyed the past 5 years.

• Major construction items such as concrete, steel, doors, drywall and lumber have stabilized and even reduced in certain categories.
• Electric and heating, venting and air conditioning (HVAC) have continued to rise but at a reduced pace.
• The decrease in oil prices over the past year has led to lower costs for items such as roofing and adhesives.
• Commodity prices have stabilized.
• Labor costs will likely continue to rise-estimated at 3-5 percent over the next 12-18 months.

All these factors combine to create a stable construction cost environment. Unless there is a sustained recession, prices/costs will not reduce. The best we can hope for is stable pricing. 

Pent up market demands and wants will eventually burst through and once again put upward pressure on construction and development costs. With occupancy rates in outpatient medical buildings currently at 94 percent, groups looking to for new or expansion space will have limited options. Accordingly, new development is likely going to be the most viable option for growth. 

Groups looking for new or expanded space should aggressively explore options in the near term before the cost structure takes another incremental jump. Delaying action will not lead to lower occupancy costs and will lead to missed opportunities to expand the patient base and grow revenue. Groups that understand this reality and take action in the near term will be much better positioned than those kicking the can down the road and then being forced to take action in a much high-cost environment.

Capital Markets: Navigating Challenges in Healthcare Real Estate

The healthcare real estate sector faces significant challenges due to persistent high interest rates and rising material costs, affecting sales volumes, development approvals, and asset valuations. Despite these obstacles, innovative financing strategies and strong market fundamentals provide optimism for future growth as industry leaders await potential rate cuts by the Federal Reserve.

The healthcare real estate sector is navigating a challenging capital market environment, impacted by high interest rates and rising material costs. The Federal Reserve has maintained the federal funds rate between 5.25% and 5.50% since July 2023, the highest in four decades, with expectations to keep rates at this level through the end of 2024 due to persistent inflation. This has led to a significant decline in sales volume throughout 2023 and into the first quarter of 2024, as higher cap rates have widened the bid-ask gap between buyers and sellers. Consequently, healthcare asset valuations have dropped by 10-20%, causing many sellers to delay their disposition strategies.

Despite these challenges, we have successfully completed acquisitions by partnering with local lenders who offer competitive terms within their areas of expertise. However, this approach has its limitations, as smaller banks have lending caps with individual sponsors, restricting the ability to scale portfolios. To counteract this, we have employed innovative financing strategies and adjusted our capital stack to sustain growth.

On the development front, high debt costs and increased material expenses have resulted in fewer healthcare projects being approved, with many systems and physician groups opting to stay in their current facilities. This has led to higher rents for tenants and a decline in hospital transactions across the U.S., which are still below 2019 levels and are expected to remain low until interest rates stabilize.

Nonetheless, the fundamentals of healthcare real estate remain strong, supported by low vacancy rates, rising demand for healthcare services, and an aging population. In June 2024, both the Bank of Canada and the European Central Bank reduced their benchmark rates by 25 basis points, raising hopes that the Federal Reserve might follow suit over the next year. Such a move could trigger a surge in acquisition and development activity nationwide, given the substantial capital ready to be deployed in the healthcare sector.

Despite challenging economic conditions and continued operational issues for healthcare providers, the medical commercial real estate sector remains a stable and strong asset class.

Revista tracks just over 20M sf of medical buildings in the Twin Cities market area that includes both multi and single tenant buildings. It shows a 93% occupied rate which has continued to hold strong throughout the pandemic and beyond. With higher interest rates, increased construction costs and material delays, we’ve seen increased renewal and expansion leases in existing product as opposed to new leases in new construction recently, which has kept net rates and occupancy up. Revista reports a 17.5% decline in new construction starts and a projected continual slowdown through the 2nd quarter.

A $22/rsf net average rate is reported, which includes some larger single tenant rates and lower rates on challenged assets that lower the overall average rate. We are seeing net rates for multi-tenant Class A space at an average of $24+/sf for existing buildings and $28–$34/sf for new construction. There is an annual increase of between 2.5–3%; this has been increasing due to higher inflation.

Lease terms for new leases remain long, often 10–20 years, so users can secure appropriate space and request high improvement allowances in the $100/sf+ range pending lease term, credit and rate.

Operating expenses continue to increase with rising real estate taxes, cleaning and utility costs averaging another $20/sf over the base rate. Gross rental rates can reach up to $50/sf which can be challenging for a sector pressured with lower reimbursements and high labor/operational costs.

Higher interest rates also slowed sale transactions and kept cap rates higher than historical levels but still in the 6% range for quality assets. However, if we see reductions in interest rates this year as projected, we anticipate increased transaction volume, including the larger REITs.

Medical building fundamentals remain strong compared to the general office market where work-from-home trends have shuttered many office buildings. An aging demographic has supported care closer to home and the desire for outpatient facilities. The healthcare sector has opted to rename the “O” in “MOB” (Medical Office Building) to Medical Outpatient Building, there are enough differentiators to warrant this effort.

With technological advancements and the need for more outpatient care, we forecast a continued strong and stable medical outpatient building sector into the future.

Ambulatory surgery centers are not just the future; they are the present. More than 50 percent of all ambulatory surgeries are currently performed in ambulatory surgery centers. The growing gap between outpatient surgeries in a hospital setting and in an ASC will not abate in the foreseeable future due largely to cost factors. Insurance companies believe they can reduce costs in half or more simply by moving surgeries from a hospital to an ASC—the same surgery done in an ASC as a hospital can cost up to 75 percent less. Patients generally prefer the convenience of not having to navigate a hospital campus and being among a much more unhealthy population. Many ASCs offer a specialty focus, providing greater efficiencies for the surgeon. Additionally, surgeons can be investors in ASCs allowing them to capture a portion of the facility fee on top of their professional fee. 

The growth in outpatient surgeries (projected to grow 25 percent over the next 10 years) coupled with the movement of surgeries out of the hospital means that the development of new outpatient surgery centers will continue for the foreseeable future. Just in the past three years, Davis has worked with its clients to develop six ambulatory surgery centers across the Twin Cities. These have included both single-specialty surgery centers and multi-specialty surgery centers. The common denominator has been a desire to develop a state-of-the-art surgery center in suburban locations that are readily accessible and highly visible.

The recently completed Eagan Specialty Center in Eagan is a compelling case study. The surgery center is a joint venture between Midwest ENT and St. Paul Eye Clinic. Having reached capacity at its Woodbury ASC, the two specialty practices explored expanding in Woodbury, developing a new surgery center to accommodate both practices and disbanding the partnership with one practice taking the Woodbury location and the other developing a new surgery center. The partners ultimately decided to develop a second surgery center in partnership because it afforded the greatest opportunity for growth and profitability.

Davis worked with Midwest Surgery Center to identify patient travel patterns, market demographics and competitor locations.  As with all real estate assignments, Davis first identified the ideal ASC location (in contrast to first identifying available options). Eagan offered the preferred demographics and best complimented the Woodbury Surgery Center and the two partner clinic locations. With a focus on Eagan, Davis secured a site that had the requisite visibility and accessibility to the major regional arteries (Davis had to negotiate access easements with the adjacent property owner and the county—these challenges had kept other developers from pursuing the property).

To ensure seamless integration, Midwest Surgery Center enlisted in-house Synergy Architectural Studio for the design of both the shell building and interior ASC. This comprehensive approach allowed the building shell to align with the ASC’s requirements, emphasizing the significance of strategic planning and collaboration in the successful development of a state-of-the-art surgery center.

The Healthcare real estate space is a dynamic landscape shaped by various economic factors and advancements in the healthcare industry. A key aspect that significantly influences acquisition strategy industry wide is the state of capital markets. The current instability in the capital markets has made underwriting assets and acquiring medical buildings more challenging than in recent years. In this article, we delve into the insights shared by Mark Davis, on how capital market changes have influenced his company strategy over the past year, future developments in the sector, Davis’ role in driving healthcare innovation, and the potential risks and rewards associated with healthcare development and acquisitions. Let’s explore how these factors interplay in shaping the future of healthcare development.

Over the past year, we’ve observed an economic landscape characterized by change— the looming specter of recession, persistent inflation, and the continued rise of interest rates. These dynamics have sent ripples through the debt markets, requiring more creativity in our acquisition strategy. Gone are the days where cap rate compression would always make an investment a success. Uncertainty within the debt markets has influenced asset pricing, property appraisals, and consequently re-financing. Furthermore, the significant bid-sell gap that persists has exacerbated the shortage of available medical buildings on the market. Owners are holding onto these properties in the hope of more favorable market conditions. Due to these factors, we foresee a reduction in acquisitions this year. However, amidst these challenges, the fundamentals of the healthcare sector remain strong, and we have continued to see a steady demand for space from health systems and physician groups. In the aftermath of the COVID-19 pandemic, providers have realized the need to diversify and expand the services offered. With this realization, we have observed both healthcare systems and specialty groups seeking expansion opportunities in existing buildings as well as ground-up developments, with a strategy focused on consolidating providers together to create a more holistic approach to patient care. One example of this is the recent 610 Medical development in Brooklyn Park. This development has united two significant healthcare entities: Allina Health and Surgical Care Affiliates (SCA). Through their partnership, a new patient-centric delivery model has emerged. This model empowers Allina Health and SCA to seamlessly cater to the entirety of outpatient surgical care demands, while simultaneously offering patients a convenient and more cost-effective solution.

Looking forward, we foresee interest rates stabilizing and the bid-sell gap coming to a healthy equilibrium over the next 24 months. This is expected to increase the supply of medical buildings available in the market. We’re also collaborating with trusted lenders, using debt swaps and caps to hedge against the downside risk of interest rate changes, positioning our portfolio for long-term success. As a full-service Healthcare Real Estate company, our expertise in healthcare leasing, acquisition, development, property management, architecture, and strategic planning strengthens our position to adapt to changing market conditions, allowing us to thrive even in a relatively down market. However, the overall landscape continues to change and at a rapid pace, making it all the more important for our team to adapt and seek out innovation in our industry that will bring increased value to our clients.

Innovation is not just a buzzword; it’s the heartbeat of healthcare’s future. Capital investments play a vital role in driving advancements and innovation in healthcare. This leads to improved patient care, healthcare delivery, and an improved healthcare ecosystem. At Davis, we take pride in developing and acquiring Class A Medical Buildings that prioritize delivering top-notch healthcare services to the community, and innovation is at the forefront. Telehealth, remote monitoring, and data sharing are some of the newest paradigms the industry is turning to. Telehealth’s potential to broaden access to care is an exciting prospect, and we envision its seamless integration with physical healthcare spaces. The synergy between these innovations will redefine healthcare delivery and continue to shape the patient journey. As we forge ahead into the future, another prominent focal point regarding innovation will be around artificial intelligence (AI). At Davis, we closely monitor the implementation of AI and its uses across the real estate industry. We believe that effective integration of AI will enhance operational efficiency and contribute to future successes, especially as it relates to tracking and measuring ESG efforts and the effectiveness of smart building technology. Sustainability stands as the cornerstone of a successful future within the built environment. At Davis, we believe that real estate holds the potential to steer the transition towards a low-carbon economy. This journey involves utilizing materials with lower embodied energy and leveraging every building-related choice to enhance efficiency and minimize emissions wherever feasible. Continuing our unwavering stance at the forefront of sustainability, we implement environmentally conscious elements such as green walls and prefabricated interior solutions. Yet, our dedication extends beyond surface aesthetics. Through the use of features like fireplaces and touch screen directories, we curate a welcoming experience tailored to meet the needs of our clients and their patients. Our commitment to sustainability, patient-centered excellence, and staying at the forefront of emerging trends positions us favorably to overcome challenges and seize opportunities in the evolving healthcare real estate landscape.