Medical office buildings shine bright for healthcare investors

Medical office buildings shine bright for healthcare investors

Bryan Lockhard

Interest in healthcare real estate continues to gain momentum despite recent challenges posed by economic uncertainty, the threat of recession and rising interest rates. According to JLL research, institutional investments hit an all-time high in 2022, reaching nearly $25 billion, a significant increase from the $19.6 and $13.9 billion reported in 2021 and 2020, respectively.

Medical office building transactions lead the pack with $12.3 billion in investments, accounting for 58% of total healthcare activity last year. Much of that, however, resulted from the merger of Healthcare Realty Trust and Healthcare Trust of America, which was valued at $9.4 billion. Excluding this merger, the numbers are a little less impressive. Quarterly trading volume between July and December fell sharply as changing economic conditions and rising interest rates dominated conversations.

MOBs reported strong net operating income in the third quarter of 2022 at 2.7%, underscoring its resilience as an asset class, despite the cloudy economic climate and its high overall spending.

Driven by high demand and slow deliveries over the past two years, doctor’s office occupancy has increased to 92.3%. This comes after a slight dip to 91.3% in the first quarter of 2020 as COVID-19 took hold.

Driven by strong occupancy growth, doctor’s office asking rents have increased an average of 2.29% over the past two years, which compares favorably to the 1.9% growth seen in the market offices overall. This trend is expected to continue as the high cost of construction and the need for proximity to patients are causing medical office tenants to stay in the same space for longer rental terms.

Ambulatory surgical centers made notable progress in terms of transaction volume last year, accounting for 26.8% of overall sales in 2022. Advances in technology, a shift in consumer preferences, and changes to Medicare and other insurance providers resulted in a shift from inpatient to outpatient care in CHWs.

Behavioral health facilities are also gaining momentum as they seek to combat prolonged isolation and increased mental health awareness, much of which was the result of closures during the pandemic. Between 2020 and 2022, 42 behavioral health facilities opened, adding 2,874 beds. 3,737 additional beds are currently under construction, demonstrating growing investment in the segment.

As with most real estate sectors, institutional investment in healthcare declined last year and accounted for just 14.9% of all transactions. Conversely, REITs expanded ownership in the healthcare sector and controlled 13% of proceeds by year-end, a 2% jump from 2019.

Short-term outlook for MOBs

As healthcare real estate faces headwinds from tight margins and labor issues, headwinds from changing demographics and the inelasticity of medical services are making medical real estate an attractive investment opportunity going forward, with MOBs seen as the biggest opportunity, followed by ASCs, and behavioral facilities.

Medical office fundamentals continue to be sound due to their resilient occupancy rates, stable rents and positive ROI growth potential. Rental rate growth is expected to be between 2% and 4%, which may temper the rise in capitalization rates.

The space for inpatient rehabilitation facilities has substantial growth potential in inpatient sites and is expected to grow 26% by 2031. There are currently 2,500 IRF beds under construction, with the majority in the region from Sunbelt.

The bid-ask spread will continue to limit trading volume in the coming year as sellers’ price expectations adjust to the higher interest rate environment. Additionally, rising rates will continue to deter some investors and higher capital buffers imposed by the Fed will continue to hamper lending activity.

Cap rates, which reached 50 basis points at the end of 2022, remain low compared to historical levels. While they are expected to experience upward pressure at the start of 2023, they should stabilize around the middle of the year.

Although interest in medical practices has increased over the past decade, 63% of healthcare real estate is still owned by hospitals, providers or the government. Given the tight margins in the healthcare industry, capitalizing on the growing interest in real estate investment could allow healthcare providers or systems to use real estate to generate cash.

While the impacts of COVID-19 were wide and varied, a recent JLL survey of 129 of the most influential leaders of specialty healthcare professionals in the healthcare space, 30% of respondents believe we have endured the worse and expect market valuations and trading activity to improve over the next 12 months.

Bryan Lockard is Managing Director, JLL Valuation Advisory.

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