BlackSwan Zine

By CJ Follini

Our economy has always had recessions and has always gotten out of them. Our economy is made up of actions and reactions. We live in free markets that buy, manufacture, invest, liquidate, hire, fire, etc. Because it is impossible to achieve economic balance between all of these activities, our economy will always be out of balance and therefore always cyclical. We are either going up, down, or sideways. Following is a look back at these cycles and guidelines for real estate investment.

Business Cycle Expansions and Contractions

Information Source: Nat’l Bureau of Economic Research, Inc.

What have we concluded so far?

• The United States economy and especially real estate, is cyclical.
• Bull markets don’t last forever.
• Recessions don’t last forever.
• The average length of the last 10 business cycles from peak-to-peak is 67 months.
• So why forecast returns over an unrealistically long 10 year holding period?

Therefore, the most important lesson we in the commercial real estate industry can take away from the current crisis is that underwriting metrics of real estate investment must be sensitive to their relative position in the real estate cycle and equity’s risk tolerance manifested in underwriting parameters should derive from understanding that cyclical position. In other words, timing is everything

To do this more effectively, Noyack Medical Partners developed the Noyack Healthcare Property Ranking (NHPR) about 7 years ago. It considers approximately 15 metrics, each weighted, to evaluate and subsequently rank property acquisitions targets relative to each other and sensitive to the real estate investment cycle while de-emphasizing subjective underwriting assumptions such as an anticipated exit cap rate.

The NHPR allows us to objectively compare several properties at a time from different locations and even at different points in the economic cycle. It’s a scoring tool the same way one uses statistics to compare ballplayers of different eras. The skill comes in utilizing an asset’s NHPR score to determine how much risk is tolerable for your company, and how much weight to give each input.

As stated above, the average peak-to-peak real estate economic cycle is 67 months, and many real estate equity participants such as private equity funds and tenant-in-common partnerships do not intend to hold an asset as long as or definitely beyond this time frame, not to mention the scarcity of  long term debt beyond 7 years. Thus, our first recommendation is to utilize a seven year forecast period instead of the usual 10 or 11 year pro forma forecasts. And by employing our Noyack Healthcare Property Rank (NHPR), we hope to better determine a property’s accurate present value relative to a moment in the real estate economic cycle.

The 15 property characteristics of the NHPR are grouped into four categories:

1. Tenancy;
2. Feeder Hospital Attributes;
3. Building Characteristics; and
4. Location Demographics.

Under the Tenancy category, the most important factors evaluated by the NHPR are lease stability; the differential qualifier; and occupancy. Lease stability is a measure of the lease expiration within the term. The differential qualifier compares the average rental rate of the property with the market rental rate, and of course, the occupancy measure is obvious.  Having a feel for your place on in the real estate cycle is critical to the tenancy category. For example, market rates increase dramatically and rapidly as we reach the peak of a cycle.  In 2007, if one looked at rental rate growth for the previous 2 years one might have surmised that annual escalations of 5-8% were the norm.  But this exactly the time to examine the length of the current cycle relative to the 67 month average and question the viability of future rental growth.

And what about an acquisition of an existing building that has near term expiration occurring towards the end of an extended cycle will have a much more negative impact then earlier in the cycle; anyone who has to backfill significant vacancy in the current environment understands this all too well. This why our NHPR looks back through the last cycle peak to trough and uses an averages of both annual rental growth and occupancy in any given market to properly account for this volatility.

Any professional with experience in healthcare real estate knows the conventional wisdom of hospital proximity to a medical office building or diagnostic facility. The mantra of “only on-campus for me” is well-worn (even though more are now debating this principle) but how many of you healthcare professionals thoroughly underwrite said hospital nearby? What’s the use of ‘on-campus’ when that campus can’t pay its bills? The NHPR not only considers proximity but evaluates and weights the quality of the hospital credit as well.

The third category – building characteristics – is the most objective and fact-based of the categories; it embodies that phrase I can’t stand, “it is what it is.” The NHPR gives relative weight to age, CapEx needs, and the all-important parking ratio. You would be surprised how often this category drags down the ranking of a potential acquisition and rightfully so because in 5 years, who will want to buy a 30 year old building with no parking even though the cash flow was great when you bought it.

Finally, though Noyack Medical has always bucked the conventional wisdom concerning “desirable location” and “proper geography” since we believe the fundamentals of healthcare delivery diverge from traditional real estate drivers, we still evaluate some attributes of a location’s demographics like overall vacancy, population growth and per capita income.

Whether we are racing toward the stratosphere or crashing faster than Jay Leno’s new show, it’s hard not to join the choir. It takes guts to zag when everyone is zigging. But a tool like the Noyack Healthcare Property Ranking (NHPR) provides dispassionate perspective and rationally evaluates healthcare property without tainting the property with assumptions borne from hysteria, up or down. It also helps to remember how long is “long?”  History has proven that 67 months is a long time for any real estate trend to outlast, not to say that it cant, but using our NHPR increases our chances of success because as we said before …. timing is everything.

The Noyack Healthcare Property Ranking (NHPR) is available as part of BLACKSWAN’s consulting services. Please send an email if you are interested to receive more information.