by CJ Follini
"If you don't like change, you're going to like irrelevance less. " - General Eric Shinseki,
Chief of Staff, U.S. Army
Even though myself and many other healthcare real estate experts expect net operating income (NOI) growth forecasted to remain constant and "in-line" with recent historical results as mentioned in Healthcare Real Estate Grows Up - Part 1
and occupancy is anticipated to remain stable, there is no denying the turbulence caused by the capital markets disruption continuing into 2009. Not surprisingly, owners nationwide are telling the same story: "the biggest challenge to MOB investment during the last 12 months has been the lending community and increased equity requirements." As big banks have all but ceased lending on commercial real estate, developers and owners have had to scramble to re-finance existing loans as well as fund new development, often turning to smaller local and regional banks that had been unable to compete with debt quotes from Wall Street in 2006 and 2007. This has formed two camps: a) those who believe the credit crunch is choking the industry, and b) those who believe the rational standards are creating opportunities galore. I am in the latter camp and I am here to say that healthcare real estate is not (nor will be) littered with distressed deals...but maybe distressed owners/sellers.
So now I have your attention and you are wondering where can I find these wonderful opportunities I speak of? Who are these so-called "distressed sellers? "
As promised, here is Healthcare Real Estate Grows Up - Part Two
Who are today's sellers of healthcare real estate and why are these opportunities?
1. Hospitals & Health Systems -
The pressures on profitability and demand for capital are driving health systems to rapidly monetize both core and non-core businesses at an unprecedented rate. Here's why many hospitals are selling more than ever.
→ Redeployment of Capital -
Hospitals and physicians need $$ to invest in expensive medical technology. By selling their real estate assets and relying on third-party ownership of new healthcare properties, they can generate the capital necessary to acquire the medical technology needed to provide more comprehensive services to patients and improve overall patient care.
→ Improve Financial Ratios
- Credit ratings for health systems have become extremely important in meeting existing debt obligations, with special focus placed on "days cash on hand." One health system executive mentioned that the spread between borrowing costs for a credit rated system, versus a non-investment grade system was between 3- to 5 percentage points for short-term bonds (12 months). *
→ De-Centralization, Specialization & Off-Balance Sheet -
There is a continuing evolution toward delivery of medical services through smaller facilities located near patients and designed to treat specific diseases and conditions. One other major item that resonated from health systems was the desire to construct new MOBs off-balance sheet. Given the reductions to operating and capital budgets, as well as endowments that are generally down between 40- to 60 percent, health systems are actively looking to have new MOBs constructed with other people's money.
→ Clinical Outsourcing
- Hospitals and larger systems, especially non-profit, moving many clinical functions (diagnostic, ambulatory surgery) to private physician groups affiliated with hospital. Thus, sell or build MOB's needed. Increasing
→ Regulation - t
hird-party ownership and management of hospital-affiliated medical office buildings substantially reduces the risk that hospitals will violate the Stark self-referral laws and complex Medicare and Medicaid fraud and abuse statutes.
→ Eliminate Real Estate Risk
→ Gain Expert Management and Development
2. Physician Groups -
two reasons, money and liability. First, physicians are people who like everyone else who have watched their investment portfolios deflate faster than Barry Bonds. Usually the most valuable asset left is their medical real estate and since current regulations prohibit gains from self-referral, it makes perfect sense for physician groups with valuable real estate to seek qualified Landlords who understand their unique management needs to cash them out.
3. TIC (Tenant-In-Common) Sponsors -
why? Also two reasons, greed and more greed. Ever since IRS amended the 'like-kind' real property definition in 2002, TIC sponsors have been hawking their wares so aggressively that Ron Popeil would blush. Then when they discovered the seemingly stable income of healthcare real estate they never looked back. TIC sponsors irresponsibly priced deals into the low 6 cap rates and sometimes even sub-6%. This is because they were only interested in generating fees and not long term returns for their investors. But several TIC sponsors are now being sued because they misrepresented that the investment was essentially guaranteed; misrepresented the terms of the loans on the property; failed to inform investors that their investments were widely considered to be a security, not a real estate transaction. So what does this mean for the prudent investor? Excellent opportunity to locate off-market deals from truly distressed sellers who don't have the time to properly market the asset even a healthy one. Search the transaction news for TIC sponsor announcements from 2004 - 2007 and start calling them. Trust me, they'll be happy to hear from you.
4. Small Developers -
Current market conditions have also forced several developers of medical office buildings
(MOB's) to the sidelines as well. According to one long-time MOB developer, "The current state of the capital markets has forced several of the more 'recent' MOB developers to exit the arena, after pushing development caps and yields to levels that did not make long-term sense." The opportunity lies in the developments that are 50% - 75% complete with the need for permanent financing to replace the construction loan. Several developers in these situations don't want to wait and see if the credit environment improves or assume the existing lease-up risk. The sense in the market is that to 30% discounts to their completion cost is available to eliminate their present value risk. For the more risk-tolerant and well-capitalized investors, these can be big winners. But you must understand the local leasing market to make this play work.
5. REO (Real Estate Owned) -
bank-owned healthcare real estate assets of quality and are performing are pretty rare if not an outright illusion. But there definitely is bank-held debt on quality medical assets available especially Class B product in secondary markets that are still performing but were the victim of the borrower's irrational exuberance (i.e. stupidity) in pricing. Where to find? The two largest bank debt sellers are Mission Capital Advisors
and The Carlton Group
. But every major brokerage house has begun a debt sales group. Get to know them...it will be worth the time.
6. Family Owned -
why would savvy real estate families sell quality healthcare real estate cash flow into this psychotic environment? You'd be surprised at the myriad of reasons from the dramatic ( they were 'Madoff-ed' ) to the common ("too management intensive at my age") to the downright mundane ( late estate planning ). Regardless, many times these deals are not the subject of lush marketing campaigns by Shattuck Hammond
or Cushman & Wakefield
but rather negotiated transactions preferred by this typ of owner for its speed and simplicity. The only way to effectively source these is the old-fashioned way: press the flesh of local brokers in your target markets. The older the broker the better. I am comfortable saying this without fear of reprisal since my Dad
worked until he was 90.
Now that you've located a couple of choice assets possibly from the above sources, how do you finance them? As one banker from a regional bank opined, "My phone didn't ring for two years, and I couldn't get a call back. However, today I am everybody's best friend - my phone is ringing off the hook, and everybody calls me back!" As reported by numerous lenders nationwide, the lone bright spot has been the relative ease in which healthcare real estate, specifically medical office real estate has been able to secure financing in comparison to other real estate classes such as office and retail. *
My suggest is to place a virtual pin on a Google map at the location of your subject property and contact every CLO (Chief Lending Officer) of a solvent regional or local bank within a 45 mile radius. Once again, its time for the old fashioned methods.
With NOI growth forecasted to remain constant, and occupancy anticipated to remain stable, even when considering recent macroeconomic impacts, there is debt and equity readily available for recession-worthy, healthcare real estate transactions. As long as we all employ sensible pricing and a detailed understanding of the fundamentals, back-to-basics investing is the new black.
* excerpts from CushWake's 2009 Medical Office Building Investor Survey