Why Colliers Believes Medical Office Sector Has the Wind At Its Back

by Scott Reid

The demand for medical office space will likely remain strong in 2016 and beyond due to an increase in healthcare spending and an aging population, according to a new research report from Colliers International.

“We expect healthcare costs will continue to rise as the Affordable Care Act (ACA) has enrolled millions of Americans who are actively using the coverage they are now paying for,” writes Michael Roessle, Colliers’ U.S. director of office research, in a white paper on the state of the healthcare real estate market.

The number of newly insured totals 17 million people, according to the RAND Corp., a research organization based in Santa Monica, Calif.

“This, combined with the projections in growth of the population 65 years and older, leads to the estimate of a near doubling of healthcare spending — from $3 trillion in 2014 to $5.5 trillion in 2024,” adds Roessle.

Healthcare expenditures currently account for approximately 17.4 percent of U.S. gross domestic product. That figure is projected to reach 18.5 percent by 2020 (see line graph).

The retail sector is expected to benefit as medical clinics, urgent care centers and other outpatient facilities lease space in shopping centers where more traditional retail tenants have closed stores.

Meanwhile, hospitals and healthcare systems are under pressure to reduce costs while increasing the quality of care. These cost pressures have led to a wave of merger and acquisition activity that is expected to continue this year.

“These hospitals and healthcare systems are seeking to improve efficiencies, reduce duplicate facilities and gain greater negotiating power with insurance companies,” writes Roessle.

Yield-Hungry Investors Compete

A combination of factors is driving the strong investor appetite, including higher yields compared with other asset classes, low interest rates and a stable tenant base with strong credit, according to Roessle.

It was a banner year in 2015 for medical office sales as capital continued to flow into the sector and strong pricing continued to drive down cap rates. The modest interest rate increases expected this year are unlikely to alter the landscape significantly, he believes.

Sales volume continued its record pace in 2015. By the end of the third quarter of 2015, the rolling 12-month total reached $12.9 billion, far surpassing the trough of $2.2 billion at the end of 2009.

Vast amounts of capital continue to compete for available investment opportunities, which has led to yields declining to near 7 percent nationally, according to the veteran researcher. Prices per square foot have reached record levels, breaching the $240 per square foot mark nationally and above $330 per square foot in the Northeast.

Healthy Vital Signs

The national vacancy rate for medical office buildings stood at 9.5 percent at the end of third quarter of 2015, a drop of 30 basis points on a year-over-year basis and the lowest vacancy rate since the second quarter of 2008, according to Colliers.

Los Angeles, Phoenix and Las Vegas have all seen strong drops in vacancy rates of medical office buildings. The decline in the Las Vegas vacancy rate — which fell from 19.3 percent in the third quarter of 2014 to 17.8 percent by the end of 2015 — was particularly strong, says Colliers. During the same period, the vacancy rate in Phoenix fell from 17.9 percent to 16.7 percent.

The stable and restrained pace of new construction during the economic recovery has helped reduce the backlog of vacancies in existing space. After a high of 24.9 million square feet of new supply delivered in the United States in 2008, the pace of deliveries of medical office buildings has fallen significantly. In 2015, for example, deliveries hovered near 4 million square feet per quarter.

According to Revista, which tracks medical real estate construction, deliveries in the medical office building sector in 2015 totaled an estimated 16.7 million square feet across 283 properties. The current pipeline of medical office buildings under construction totals 38.7 million square feet in 542 properties with a value of $18.3 billion.

Absorption Remains Positive

Several years of strong positive absorption — including the period from 2012-2014 when annual totals were between 8.5 million square feet and 10.2 million square feet — combined with the limited new supply of the last few years has fueled the steady drop in vacancies and increases in asking rents across the country, according to Roessle. During the first three quarters of 2015, absorption of medical office building space registered gains of 5.8 million square feet nationally.

Barring any unanticipated shocks to the U.S. economy, strong absorption should continue for the short term “as the measured pace of strengthening in this sector suggests this is not part of a bubble typically signified by abnormally rapid growth,” according to Roessle. “Still, the dynamic and complicated changes facing the healthcare industry could alter these variables in the long-term and should be monitored.”

Rental Rates Reflect Stability

In the third quarter of 2015, rental rates for medical office space posted an annual gain of 4.1 percent, reaching an average asking price of $22.95 per square foot. That marks the third consecutive year of asking rent increases, and the highest figure since hitting $23.10 per square foot in 2009. Even with these recent increases, asking rents have remained relatively stable, fluctuating less than $1 since 2007.

By comparison, asking rents in the general office market have also experienced positive growth with Class A properties in CBDs rising 6.8 percent annually to $48.62 per square foot, and suburban Class A properties increasing 3.5 percent to $28.59 per square foot. Class A office properties in the CBD have experienced five straight years of rent increases while suburban properties have registered four consecutive years of rent growth.

— Scott Reid

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