Long-Term Medical Office Demand Remains Strong

Long-Term Medical Office Demand Remains Strong

from Marcus & Millichap

The U.S. added 1.5 million jobs over the past year, providing health insurance to many individuals who lost coverage during the recession. This trend, combined with a 2.2 percent gain in healthcare employment, drove stronger demand for medical office space. At the same time, completions declined, with year-to-date deliveries down 12 percent from 2010 and 80 percent below the peak three years ago. While construction starts have started rise, caution persists. Pure speculative development has come to a halt, and commitments have already been secured for nearly two-thirds of the space under way. Over the next several years, developers will focus on multi-tenant buildings with strong pre-leasing and off-campus facilities, including treatment and surgery centers, as hospitals grow market share by way of off-site expansion.

At 11.5 percent, medical office vacancy has retreated 70 basis points from its late-2009 peak, though it remains 140 basis points above pre-recession levels. Performance varies dramatically by metro, however, as several areas already boast vacancy below late-2007 levels. Outperforming markets are concentrated in Texas, parts of the Midwest, and high-barrier-to entry coastal areas of the Northeast. Many markets in the West, Mountain and Southeast regions, on the other hand, remain particularly weak as they contend with oversupply conditions created by significant speculative development during the housing boom. Fortunately, medical office demand remains poised for strong growth, with the 65-year-old-plus segment of population forecast to expand by 36 percent, or 15 million individuals, over the next 10 years. This age group averages twice the number of office visits per year than the broader population. Additionally, healthcare reform could potentially bring coverage to an estimated 35 million uninsured individuals.

While space demand will accelerate in the years to come, several factors may hamper rent growth. To start, doctors will continue to battle against higher expenses as cutbacks in reimbursements place pressure on their bottom lines. In addition, owners may need to offer more generous tenant improvement allowances or invest in upgrades to accommodate larger practices, ongoing technological advancements, or to transform file storage areas into functional space. Year to date, asking rents for medical office buildings declined 1.2 percent to $23.73 per square foot, placing the average more than 5 percent below pre-recession levels.

Transaction velocity increased 10 percent this year, though dollar volume declined due to fewer major deals. Activity in the $20-million-plus range slipped 60 percent as hospital transactions slowed and REIT acquisitions returned to more normalized levels, following last year’s surge. During 2010, REITs accounted for 43 percent of all sales, up from an average of 29 percent in 2008 and 2009. Year to date, REITs’ market share hovers around 20 percent, with private investors once again dominating the market. With fewer large, top-quality deals, the median price dipped 6 percent to $188 per square foot. Nationwide, cap rates average in the low-8-percent range, though top-tier hospital or diagnostic/treatment facilities start between 6.0 percent and 7.5 percent, while Class B deals or those in secondary/tertiary locations typically trade between 8 percent and 9 percent.

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