BlackSwan Zine

By Kenneth Meyer and Rob Grossman for Deloitte Consulting LLP

Now that the new Patient Protection and Affordable Care Act has been signed into law, businesses are scrambling to determine what impact the reform will have on their bottom line. At first glance, the impact on the real estate industry might not be self evident. However, the reform presents a unique opportunity for growth and innovation for the challenged Commercial Real Estate industry.

It has been well established that the recession has battered real estate; occupancy levels across all asset types have suffered dramatically. While healthcare reform alone cannot be expected to unilaterally revive the real estate industry, it does present a welcome opportunity in the form of accelerated demand-driven absorption for certain segments.

Historically, consumption, and thereby growth in demand for real estate, would be driven by factors such as population density or increases in wealth. The new healthcare legislation changes several important demand drivers for real estate by introducing alternative models for the delivery of medical services as well as a significantly enlarged population of insured Americans who will receive healthcare differently.

Today, approximately 46 million Americans are uninsured. Early estimates suggest that 32 million will receive insurance coverage under the new legislation. Using an industry multiplier of 1.9 sq ft required per patient to estimate the net effect of additional patients on space utilization, it can be estimated that 64 million additional square feet will be required to meet the increased demand.1

In order for the real estate industry to benefit from this shift in consumption, the demand for space must be met by the space that is currently available. Since the demand for additional medical space will begin almost immediately, the industry cannot afford a lag due to development of new medical office buildings, nor can the industry continue to thrive by building more square footage without addressing current square footage absorption. This white paper will address the potential immediate impact of healthcare reform on the real estate industry and how an innovative approach can support a winning strategy.

Meeting the new demand

The current economic crisis and tightening capital markets have severely limited the development of new medical office space. With only 7 million (appox.) square feet of medical office space scheduled to be delivered in 2010, owners and operators of other Commercial Real Estate asset types have an opportunity to capitalize on the increased demand, and the restricted supply of medical office space. High vacancy rates in retail and office make both sectors ideal candidates to absorb the increased medical demand. Recent developments in retail and office leasing confirm that this is a viable solution for increased demand for healthcare related space, as well as a welcomed opportunity for two of the most severely battered segments of the real estate industry.

While office space has historically held a small portion of medical offices, the retail sector is a newer concept. The benefit of meeting the need for space for the medical office industry is that health services are not tied to any particular asset type. In fact, a 2006 study of medical service preferences revealed that consumers are more likely to visit retail locations for certain services:

• Wellness Programs (e.g., weight loss, smoking cessation)

• Preventative Care (e.g., flu shots, cholesterol tests)

• Urgent/Unplanned Care that requires a prescription

Retail clinics – disruptive innovation

Retail clinics are an important and growing part of the U.S. primary care delivery system.2 A 2008 Deloitte report Retail Clinics: Facts, Trends and Implications stated that retail clinics, which can be found in pharmacies, grocery stores, and big box retailers (i.e. Wal-mart, and Target). “…are not a fad – they are a disruptive innovation with a sustainable value proposition (price, quality, service) that is welcomed by consumers.“

The market for retail clinics is still relatively new and emerging. As of February 2010, approximately 1200 retail clinics are in operation; CVS leads the market with 569 retail clinics in 25 states and the District of Columbia. Prior to the enactment of healthcare legislation, some outlets were reconsidering their plans to expand retail clinics due to the prolonged trajectory for profitability. One study of Walgreens and CVS’ retail clinics suggests that “for a retail clinic to be profitable, providers must see between 17-23 patients per day with breakeven in the 18-24 month time horizon… [profitability] should improve if patient volume continues to increase.”3 Recent changes in healthcare legislation should help to drive demand and support profitability.

As a cheaper alternative to hospitals, walk-in clinics may further emerge as a result of the legislation. With a larger segment of people now afforded health care insurance, stores such as Wal-Mart have plans of rapidly expanding their hospital-connected clinics. The National Center for Policy Analysis estimates that the number of retail clinics is expected to reach 3,200 by 2014, nearly three times the current number of retail clinics.4 “Typically staffed by physician assistants or nurse practitioners…the hospital retail clinics can operate at relatively low cost compared with primary-care doctors’ offices or emergency rooms.”5 These lower costs will be particularly attractive to those newly insured patients that have difficulty finding a primary care physician that is willing to accept their form of insurance and who desire the convenience of walk-in appointments at these big-box clinics.

Retail outlets for increased visibility

There is a second component to the retail strategy that not only leverages the space available in retail outlets, but also benefits from the increased visibility and the established audience that can be found in malls and shopping centers. Medical institutions have begun to explore the benefits of high visibility retail locations for health education/outreach storefronts. These storefronts are appearing in malls alongside clothing retailers and food outlets, with the intent to “piggy back” off of the built-in audience available in day to day shoppers. In Bloomington, Minnesota, the Mayo Clinic has committed to occupying space in the expansion of the Mall of America. In Baltimore, Maryland the University of Maryland Medical System has operated an educational storefront in Arundel Mills for the past 4 years. Preventive care and health education will become more prominent as a part of the new health care legislation, and retail space dedicated to health education could see a boost in the near future.

While retail clinics can actually help increase a shopping center’s foot traffic, a health education storefront may depend on existing foot traffic. Thus, owners/operators need to determine which complement of healthcare facility growth opportunities to pursue based on their current operations. Since these outlets are still considered experimental changes to the medical services operating model, real estate owners/operators need to begin developing strategies to help these operations prove effective. Consider the following strategies:

• Proactive space planning for an expansion of a pharmacy to include on-site clinics, which can provide an immediate opportunity to utilize vacant space in retail centers that are already occupied by pharmacy tenants

• Incentives (i.e. tenant improvement allowances) for retailers that operate on-site clinics

• Marketing strategies that promote the advantages of leasing space for clinical services and/or health education in customer friendly, convenient retail locations

• Healthcare shopping centers – a one stop shop for surgery, education, and other amenities such as banks and cafés

• Healthcare kiosks in retail location for self-service health education

Adjusting for unintended consequences

Early assessments of the healthcare legislation suggests that the reform may have unintended consequences for the healthcare industry and related services. Specifically, hospitals, insurance companies and private physician practices are key areas to watch because of the legislation’s direct impact on their operating models, and cost structures. As the bill unfolds, several outcomes are possible. A study conducted by Deloitte highlighted several of the potential impacts possible for the key areas as follows:

The new legislation may increase the utilization of ancillary services and inpatient services as the newly insured group is now able to seek preventive medical care, rather than reactive medical attention. This phenomenon, coupled with reduced reimbursement rates and greater regulatory requirements through the newly created health plans, points toward a higher volume, lower margin system. In response, a larger number of physicians, especially those serving less affluent communities, may look to sell their practices to hospitals, as many of the physicians will no longer have the incentive or the capacity required to address the logistics.

Other physicians, especially those serving the affluent segment of America, may migrate away from insurance (e.g. negotiated rate PPO-type) supported models, electing to serve only those patients who pay privately for physician concierge services. Concierge services typically require a patient to pay a retainer for the privilege of receiving customized service.

Consolidation into hospital systems and the expansion of concierge practices could drive demand for real estate supporting healthcare related businesses. Concierge practices would likely require large, high quality real estate in more costly locations. While traditional medical offices, especially those associated with a hospital, may require additional space proximate to hospitals for doctors or clinics that want to minimize their newly strained back-office responsibilities. The effect of which will be a growth in demand for real estate near hospitals to support the expanded and differing delivery models for meeting the new standard of public care and an increase in the value for space close to hospital centers. In addition, there may also be an increase in demand for space to support the concierge practices in more affluent areas.

What’s next? Investing in the future of healthcare

At this early stage, it is difficult to predict the full impact of the healthcare legislation on real estate. However, there are several opportunities that the real estate industry should continue to prepare for by gaining an understanding of how area demographics, economic factors and market conditions in conjunction with healthcare reform will impact the future performance of real estate.

Office space: Opportunities for conversion and enhanced utilization

In Massachusetts, where universal healthcare was enacted in 2006, sales of medical office buildings rose every year through 2009. In 2008, medical office transaction velocity rose 32%.6  Considering the shortage of medical office building space currently available, owners of smaller office buildings (under $10 million in value) have the opportunity to convert their space and their focus to meet the medical office community needs for rent and for sale. Is your property prime for an industry conversion? Consider the following:

• Proximity to a hospital: Medical office space is often located near a hospital to allow doctors to work in both environments, and to allow patients to easily travel from one to the other

• Amount of contiguous space available to be converted into examination/operating rooms, waiting areas, labs etc.

• Demographic of the surrounding area and the types of services demanded

• Feasibility of conversion and sale of office space into office condominiums targeted to the healthcare community

In addition, demand for office space to support ancillary healthcare related services such as insurance claims processing and medical billing are expected to grow. Proactive real estate organizations should be considering how their existing portfolio currently serves this market and how to expand their share of this growing segment of the economy.

Identifying target markets

While healthcare reform will undoubtedly heighten the number of insured individuals that will require a physician, not all segments of medical care providers will grow proportionally, nor will all markets/regions be impacted in the same way. Industry experts predict that lower reimbursement rates for doctors from the newly insured segment will drive the growth of mid-level providers and clinicians. Uninsured Americans will have the opportunity to visit medical providers – however, that does not mean that they will have a primary care physician. In a 2008 study conducted by the Center for Studying Health System Change, surveys indicated that almost 14% of physicians accept no new Medicare patients. Primary care physicians are significantly more selective than the group as a whole.7 This, coupled with the increasing shortage of physicians in the pipeline, will only serve to make physicians more selective in which provider plans they accept. With a greater percentage of the population insured by plans with lower levels of reimbursement, primary care doctors (who often lose money on Medicaid patients) may become more selective in targeting patients.

In addition, the demographics of the uninsured are concentrated and will likely mean that opportunities for growth in consumption of medical services will be significantly higher in urban areas where there are a greater number of uninsured Americans. As such, the geographical locations of the uninsured must be considered when determining how to serve this population.

Diversifying the tenant portfolio

The combination of affordability and the non-cyclical demand of medical care bodes well for both increases in the number of visits, and the dollar spend per person for medical care. In addition, the steady decline in hospital beds signifies a growing preference for outpatient care.

Adding medical care facilities to a tenant mix can provide diversification for an owner/operator needs to defend against changing market conditions. A recent study of Fitch-rated Real Estate Investment Trusts (REITs) in the U.S. further illustrated the strength of the healthcare real estate sector. In 2009, Healthcare REITs were the only property type that did not receive a downgrade by Fitch. In fact, during that same period two healthcare REITs actually received ratings upgrades. Fitch attributes the Healthcare REIT strength, in part, to:

• Long-term, stable leases

• Diversity of income sources (i.e., insurance companies, government reimbursement, and private sources)

• Diversity of tenants within the healthcare industry, which go beyond doctor’s offices and clinics to include such tenants as:

– Assisted living facilities

– Pharmaceutical companies

– Biotechnology companies

The strong tenancy components that are common among healthcare REITs can be extended to other asset types that seek to serve the healthcare community. Strong tenancy is a key component for assessing value and risk, both of which are increasingly important for access to credit and stable income.

The Deloitte approach

We expect that demand for medical services will increase, consumer preferences will change, and the healthcare industry will innovate. The extent to which these changes will impact the real estate industry will vary based on several external factors such as availability of medical services and the consumers’ dollar spend on healthcare. This paper highlights several trends already underway within the healthcare sector that are forecasted to have a positive trajectory over the next 4 to 5 years. Deloitte’s current and future participation in research and client engagements within the healthcare industry will continue to provide early insight into trends forthcoming in the healthcare industry.

Real estate owners/operators have an opportunity to assess their current performance and determine how they can most effectively leverage the growth of the healthcare industry. Every asset/portfolio differs in its areas of strengths and weaknesses. Thus, a winning strategy will require both deep knowledge and perspective of the healthcare industry, and an understanding of the trends, challenges and benefits for the real estate industry. This is where Deloitte can help. Our deep industry knowledge and access to specialists in both healthcare and real estate makes us uniquely qualified to assist our clients in determining the most effective approach for meeting the imminent demand. We have a long standing reputation of helping our clients address changes in economic, regulatory and market environments, and look forward to developing industry leading strategies for Commercial Real Estate.

Authors: Kenneth Meyer, Principal,Deloitte Consulting LLP
Rob Grossman, Principal, Deloitte Consulting LLP

1 National Real Estate Investor, Health Care Reform: Boon for Commercial Real Estate?, 2010. Page 1.

2 Deloitte Center for Health Solutions, Retail Clinics: Facts, Trends and Implications, August 2008

3 Thomas Wiesel Partners, Pharmaceutical Services: Industry Overview, 2008

4 San Antonio Business Journal, Retail Health-Clinic Industry is Primed for Expansion, January 2010

5 New York Times, Hospitals Begin to Move Into Supermarkets, May 2009

6 Marcus Millichap, Healthcare Reform: A Winning Prognosis for Medical Office Investments, 2009. Page 3.

7 Center for Studying Health System Change, Key Findings from the 2008 Health Tracking Study Physician Survey, September 2009.

9 US Department of Labor

10 The Complexities of Physician Supply and Demand: Projections through 2025, Center for Workforce Studies, Association of American Medical Colleges, 2008.