Rising interest rates will benefit buyers with access to capital
Investors focusing on the medical office building (MOB) market in 2023 will be able to take advantage of favorable valuations as interest rates climb.
That’s the message from Eric Lewandowski, managing director at KPMG. Lewandowski, based in Detroit, is involved in 10 to 20 MOB deals per year on the sell and buy sides.
“There is increased pressure on valuations given higher lending rates, which is likely to work against valuations,” Lewandowski said. “Opportunistic buyers with access to lending may be swayed by value-focused buying opportunities and decide to take the expensive financing upfront with a plan to refinance at lower rates in time. There will be a lot of opportunities in mixed-tenant MOBs. For investors who have a new fund, they will find good deals early in 2023.”
The Federal Reserve raised borrowing costs by 50 basis points to a 15-year high on December 14 as the U.S. central bank continues to fight inflation.
Despite the acquisition opportunities that may exist next year, Lewandowski forecasts a drop in MOB deal activity in 2023 as borrowing costs escalate.
“There will be a slight reduction, but I think many of us are still waiting to see what a potential recession could look like and the impact of that,” said Lewandowski, who did not provide specifics when asked to give a forecast for a reduction in deal volume in 2023.
J. Brannen Edge III, managing partner, president and CEO at Flagship Healthcare Properties, LLC and Flagship Healthcare Trust, Inc. in Charlotte, North Carolina, also predicted the higher interest rates will cause a slowdown in activity in 2023.
Flagship focuses on clinical outpatient healthcare properties — such as MOBs and ambulatory surgery centers (ASCs) — because of the strength of the tenant base, the relatively low percentage of the overall cost that rent comprises, the stickiness of the tenants and the demographic growth (the senior population and overall population) in the southeastern U.S.
Flagship targets 10% to 14% net annual returns to its investors. Roughly half of this return is anticipated to be capital appreciation derived from NOI growth as well as occupancy stability and growth, and about half of the return is via dividend income.
For 2022, Flagship is forecasting approximately $180 million for its acquisition volume of MOBs and ASCs, which would match the same level as 2021. Last year that volume was over 17 buildings. In 2022, the volume will include more than 21 properties.
“While higher rates will stunt activity, somewhat, it is the uncertainty for where rates and the economy will ultimately settle that engenders a gap between seller and buyer pricing expectations,” Edge said. “This price discovery will take several quarters to conclude.”
John Chang, senior vice president, national director and research services at Marcus & Millichap Real Estate Investment Services, said the speed with which interest rates rose in 2022 created a “temporary disconnect” in the market.
“Buyers and sellers are recalibrating their expectations to align with the rapidly changing cost of capital,” Chang said. “The widening of the expectation gap slowed transactions in the fourth quarter, but if the Federal Reserve slows its pace of rate increases, buyers and sellers should be able to navigate the price discovery process and transactional activity should revive. Transaction activity will likely stabilize in 2023, but the higher interest-rate climate has put upward pressure on cap rates which means the pool of sellers will likely be somewhat limited.”
Any reduction in deal activity would be a reversal in the explosive growth seen in MOB deals in recent years.
According to the LevinPro HC database, 203 Medical Office Building deals were reported this year through December 9. This compares with 140 MOB transactions recorded during the same period last year and 67 MOB deals between January 1, 2020, and December 9, 2020.
“There were several factors coming into 2022,” Lewandowski said. “We had cheap lending costs and that led to people starting to use that inexpensive lending to go and start to acquire. Additionally, a lot of REITs and private equity funds had capital that they were holding on to and they wanted to deploy that capital more aggressively. And people were flocking to assets that were relatively safe. MOBs are deemed to be a safe asset class compared to other types of assets. Also, medical office buildings were deemed to be critical throughout COVID and largely stayed open.”
Edge also observed market strength in 2022.
“Institutional dollars continue to flow into the sector in recognition of the stability and recession-resistant cash flows inherent in the MOB sector,” said Edge, who also mentioned that the relative attractiveness from a cap rate perspective — when compared to sectors such as multi-family and industrial — has kept MOB investments popular. He also covered other factors contributing to the elevated level of MOB activity such as high occupancy and tenant renewal rates, low instances of tenant defaults, a high level of investment by tenants in their leased spaces and the aging of the population.
“Medical office buildings offer investors a unique combination of investment advantages in the current economic climate,” Chang said. “They offer a comparatively high yield, strong long-term, demographically-driven underlying demand drivers and usually they have long-term leases with inflation escalators. Investors targeting lower-risk assets with comparatively low management requirements and long-term upside potential have been active purchasers.”
Chang observed that during the first half of the year, investors benefited from low-interest rates and many transactions occurred as the Fed pushed rates up.
“Entering the second half of the year, transaction velocity has slowed. Sellers are in the process of adapting to the high-inflation, high-interest-rate climate,” Chang said.
Chang added that investors are focusing on the long-term comparative durability and safety of MOBs.
“They are favoring longer-term leases of 10-plus years that include 3% annual inflation escalators,” Chang said. “Investors also favor assets with significant medical-focused infrastructure and tenants with significant specialized equipment that is difficult to move, signaling long-term tenant reliability.
“Most medical office properties are relationally more secure than most other property types. There are nuances that come into play.”
Chang identified mental health facilities as likely having a higher risk profile than equipment- intensive assets like surgical centers.
“The upside potential comes from potential inflation-driven yield gains as well as long-term demographic demand drivers,” Chang said. “As people age, they utilize more medical services. Over the course of the next 10 years, the population aged 65-plus will increase by 28% and the population aged 85-plus will increase by 25%. This will boost demand for medical services and should bolster medical office space demand.”
Quarterly analysis of the data reveals that a market slowdown may be underway.
“Higher interest rates have depressed activity, beginning in the summer of 2022,” Edge said. “Pricing and sales velocity has slowed in the past three to six months. For Flagship, our average stabilized cap rate for purchases completed or slated to be completed in Q4 is ~6.6%. For the first three quarters of the year it was ~5.85%. So we have seen an approximate 75 basis point increase, at minimum, thus far.”
MOB deals this year have totaled 56 in the first quarter, 47 during the second quarter, 61 in the third quarter and only 39 so far during the fourth quarter.
“Valuations are starting to be compressed with rising interest rates increasing recession risk,” Lewandowski said.
Lewandowski was asked if the MOB M&A market was recession-proof.
“I don’t know if I would say it’s recession-proof, but it certainly has recession resistance,” Lewandowski said. “It has more recession resistance than other real estate classes, certainly more than commercial real estate. Medical office buildings provide safety and a sense of recession defensibility given the critical nature of the tenants involved. I would say it is a safe place to consider investing.”
Edge was also asked the recession-proof question.
“Nothing is recession-proof,” Edge said. “But history has shown that health care has relatively inelastic demand. Whether the economy is in a recession, or is in an expansion, cavities do not fill themselves on their own. ACLs do not repair themselves without surgery.
“Even with continued interest-rate rises expected and the potential for a recession, MOB activity will remain elevated in 2023 due to the strong fundamentals and relative underinvestment, compared with other property sectors, by institutional investors. Occupancy rates will remain relatively steady. The high cost of construction and supply-chain issues, resulting in higher rental rates, makes for an uphill battle for tenants to vacate existing space in favor of new space, unless existing space is too small or functionally obsolete. Demand for healthcare services will continue to grow, which should keep space delivery, absorption and occupancy rates at or near current levels.”
Chang echoed Edge’s analysis.
“No investment is truly recession-proof,” Chang said. “There are always nuances and variables that can work against the durability of any investment. Medical office properties have increased resistance to recessions because they benefit from positive demographics, long-term leases and the normally specialized nature of the properties.”
Chang also mentioned that Investors have been more focused on Sun Belt markets where the 65-plus population is growing fastest. However, he said many investors place more emphasis on the type of medical office asset and the lease structures than they do on specific metros.
“Although investors have favored properties with specialized infrastructure and equipment such as surgical centers, investors are more focused on the tenant quality, lease structures and overall building quality,” Chang said.
Edge was asked how much development must increase to keep up with demand.
“This is market-specific,” Edge said. “While the national occupancy rate for MOBs is 90% to 92%, markets vary materially. Some markets, or more specific submarkets, have no material availability for Class A MOB space. Other markets have witnessed overbuilding and have excess space that still needs to be absorbed.
“Flagship is focused on the Southeast and Southern Mid-Atlantic U.S., with investments in MOBs from Maryland in the north, down through Florida in the south and west to Arkansas, Kentucky and Tennessee. We see growth in all markets in which we operate.”
Edge said newer buildings dominate the MOB market.
“Older buildings which are not functionally obsolete and can be brought up to today’s standards are also trading hands,” Edge said. “Portfolio sales of multiple buildings have become more difficult as bank financing has become more stringent and expensive.”
Chang also commented on the relationship between development and demand.
“The market has delivered an average of about 11 million square feet per year since 2010 and has generally remained stable,” Chang said. “Although medical service demand drivers will likely suggest increased space needs, the actual leasing demand may be mitigated by a shortage of medical professionals and by increasing use of technology that bolsters efficiency and reduces medical space demands.”
The emergence of virtual care was something Lewandowski characterized as a growing trend that will not impact MOBs as significantly as other investments where digital technology has taken hold.
“It will depend on the specialty,” Lewandowski said. “I think it will have a greater impact on general practice physicians. You can virtually do your annual checkup and other very basic types of medical care using digital platforms. Specialists are in a better position from a medical office perspective. They should be protected from any emergence of a digital platform. The more specialized you get with a particular medical condition, the more there is a need to be in the office and the less likely it is that a digital platform could replace the physician providing that service, and therefore the stronger the value of those specialists positions in a medical office building. The tenant value is higher for specialists. With dermatologists, for example, office care is better than virtual care. Specialists need to be in an office.”
Chang was asked to provide a prediction regarding occupancy rates.
“Limited supply pressure, with estimated completions down modestly to 0.8% of inventory in 2023, should help restrain market softening,” Chang said. “Occupancy rates are forecast to rise 10 basis points to 90.9% in 2023. One factor that could weigh on medical office space demand in 2023 is the labor shortage, particularly among medical professionals.”
Lewandowski drew a connection between MOBs’ performance during the pandemic and relatively high occupancy rates.
“M&A broadly across health care has increased,” Lewandowski said. “Especially with medical office buildings, occupancy has been a factor because compared to other asset classes it was resistant to COVID. It became more attractive to investors as they saw that play out coming out of COVID.”
Lewandowski also sees some tenants leaving MOBs and strengthening other asset classes.
“I think there’ll be opportunities to think about tangential asset classes,” Lewandowski said. “Within medical office buildings what you find is that there can be a mix of different tenants. I think some of those tenants will emerge as more of a standalone asset class and will grow in popularity at scale with the largest one being ambulatory surgery centers.”
Lewandowski forecasts that in 2023 there will be opportunities to capitalize on historically “harder to aggregate, but highly valued” medical real estate beyond traditional mixed-tenant MOBs.
“One example is the emergence of ambulatory surgery centers, which traditionally have received fewer concentrated investment dollars than other kinds of medical real estate given that ASCs can be smaller assets, or are part of a broader MOB platform and can be harder to segment as a standalone asset for a focused portfolio,” Lewandowski said. “I predict that you will see more REITs begin to build portfolios at scale which are focused specifically on these assets as opposed to being mixed together with other kinds of MOB tenants. Ultimately, these ASC-focused portfolios could trade at higher multiples given they support continued healthcare trends around shifting patient care to lower cost of care locations.”
So far this year there have been 27 ASC deals reported. This compares to 25 ASC transactions during the same period in 2021 and 11 such deals between January 1, 2020, and December 9, 2020.
“Within health care more broadly there is a shift toward providing care in lower-cost environments, and with that ambulatory surgery centers have grown significantly in popularity over the past few years and that will continue,” Lewandowski said. “Ambulatory surgery centers will emerge as a more prominent standalone asset class and one that has higher valuations because of those broader healthcare trends shifting care to lower-cost locations, instead of ambulatory surgery centers largely being tucked into a multi-tenant medical office building.”
Lewandowski also forecasts a shift toward more diversified MOB REIT portfolios that he described as having “a greater percentage of medical office building-branded portfolios containing non-medical office building healthcare real estate for further blending and diversification.”
Whether MOB deal activity peaks in 2022 remains to be seen. But we believe that rising interest rates and what that does to valuations will significantly impact deal volume in 2023.
