BlackSwan Zine

An HFMA Healthcare Financial Pulse Resource

Although residential real estate markets remain mired in a widespread and persistent slump, commercial real estate investors continue to see opportunity in the healthcare market. As a result, many health systems are carefully eyeing ways to derive cash from their balance sheets by selling some of their real estate holdings—particularly medical office buildings.

For Carolinas HealthCare System of Charlotte, N.C., which recently divested 15 medical office buildings for $162 million, the conversion of these assets is a sensible alternative to more constrained and expensive sources of capital.

“For our health system, our free-standing medical office buildings represent a significant opportunity,” says Greg Gombar, CFO for Carolinas, which owns or operates 25 hospitals. “That $162 million is money that we now do not need to raise in the debt markets, and it significantly strengthens our balance sheet. In addition, there’s an opportunity cost that is avoided with that capital not being tied up in real estate.”

The transaction is part of a careful strategy at Carolinas to manage its building assets. “This doesn’t apply to buildings with beds, operating suites, large imaging devices, or other major clinical equipment or other facilities with regulated assets. Those buildings are a little more central to our mission and we want to retain ownership of those. But, as a strategic principle, we don’t want to own medical office buildings on our balance sheet,” says Gombar.

“However, we do think that it makes sense to build them. We can do that faster and less expensively than partnering with a developer,” he says. “Typically, a developer has to find and buy the land and get it 70 percent leased before breaking ground and obtaining financing. We can do that much faster and bypass a lot of those hurdles. We can specify the exact parameters of the interiors to suit our needs and, when they’re ready to go, we monetize them by flipping them to investors. This eliminates the need for us to staff, operate, and maintain these facilities,” says Gombar.

An Attractive Haven

“Investors are seeing this as an attractive haven,” says Mike Lincoln, executive vice president, Lillibridge, a national developer and owner of healthcare real estate. “The demographic-driven demand for health care is only going to grow. You don’t want to call any investment ‘recession-proof,’ but people will need medical care. Also, the tenants in these facilities tend to be ‘stickier’—so the cash flows tend to be more stable over the long term.”

Lincoln believes that sellers will still find cap rates at historically attractive levels for better-quality products. “Long-term interest rates and cap rates are closely correlated, and indications suggest that both of them are heading up,” he says. “That being said, we expect that sellers of stabilized, on-campus properties will find significant market demand.”

“But more importantly, this strategy makes sense for healthcare financial executives,” says Lincoln. “The fact is, many hospitals and health systems don’t want to be in the real estate business as it is often not a core competence for them. Other parties are better suited to owning and operating these facilities and have the resources to do so. For the health system, these transactions create an excellent opportunity to focus on healthcare delivery, while injecting some much-needed liquidity into their capital-intensive enterprises. It’s enabling them to free up money to reinvest in their core business and protect the balance sheet.”

Market Heating Up

According to E. Hunter Beebe, principal with Healthcare Real Estate Capital (HRE Capital), more healthcare-related real estate assets will likely be headed to the market after a couple of quieter quarters. “In the first quarter, there were fewer transactions brought out, but the market is picking up,” he says. “We’re finding a significant amount of equity is still interested in the sector, and the investors are still very interested in quality transactions with good hospital sponsorship.

“As long as there isn’t a dramatic spike in the supply—which could be brought on if there were a significant distressed operator that needs to recapitalize—we think the equity that’s out there now can absorb the typical annual inventory of product.”

As far as volume increasing due to hospitals needing capital, Beebe says: “We have a significant amount of monetization projects we’re working on currently and others we are looking at—both large and small. Most hospital systems implement these transactions for a variety of strategic reasons, in addition to a desire to access capital. The key for a hospital system is to put a lot of thought in upfront regarding their overall long- and short-term goals as a healthcare provider, goals for the particular asset, and their current and future space needs. When those issues have been appropriately analyzed, a determination can be made as to what type of transaction best achieves those goals. The idea of a hospital rushing to a transaction for capital is not something we have seen or would recommend to our clients.”

Tim Schier, senior vice president with Cain Brothers, expects pricing to remain attractive for sellers—a key reason for the steady volume in medical office buildings. “We haven’t seen the kind of downward movements in pricing that we’ve seen in other asset classes, such as retail or commercial office space,” he says. “Those sectors have seen cap-rate drops of 300 basis points or more. In medical office buildings, it’s been 100 to 150 basis points. And, from a historical perspective, current cap rates in the 8.0 to 8.5 percentage range are still attractive. While there may not be a significant number of closings in early 2009, I think a lot of transactions will close in 2010.”

Characteristics of Ideal Transactions

Since 2004, pricing has become competitive as investors are recognizing that medical office buildings have moved beyond a quirky asset class into a desirable investment vehicle. Additionally, pure medical office buildings are not the only type of medical properties being transacted.  “A typical property that sells in the medical arena is a 50,000 square-foot, three-story medical office building,” says Schier. “But there’s a lot of variation. Imaging facilities, rehabilitation hospitals, and ambulatory surgical centers turn over with regularity as well.”

While medical office building sale prices vary significantly across regions and are subject to non-trivial volatility, sellers are typically receiving $125 to $300 per square foot, compared to sale prices of $100 to $125 for commercial office space. Prices tend to run a little stronger in the Sun Belt where there are higher concentrations of retirees who access high levels of medical care.

“Hospitals need to recognize that, in some cases, they are sitting on significant assets in the form of these medical office buildings,” says Lincoln. “These types of transactions are appropriate for virtually any size health system. While there are legitimate issues to analyze with respect to total long-term costs, the current financial environment and credit crunch means hospitals and health systems are smart to look at various strategies to leverage underutilized areas of the balance sheet to achieve alternative forms of liquidity.”

Schier adds: “Hospitals should view the potential sale of medical office buildings not necessarily as an opportunistic transaction, but as part of a long-term strategy to manage assets, improve the balance sheet, and pursue the healthcare mission. Careful planning and long-range thinking are essential to making this strategy a success for hospitals.”

Michael Dowding, of Wordscape Communications, is a freelance writer based in Millis, Mass.

by Michael Dowding for HFMA

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