When you Google "the most recession-proof commercial real estate industries," medical office comes up in nearly every article displayed in the search results. I attended the InterFace Healthcare Real Estate national conference in September where there was much talk about the industry's headwinds.

Fortunately, the underlying fundamentals of healthcare real estate remain sound. The sheer number of Baby Boomers over 65, their chronic conditions and their need for medical attention will ensure that demand for more convenient sites of care will remain strong for the foreseeable future.

Capital Markets Tighten

What a difference a few months makes. Meridian closed escrow on 3901 Broadway, a 56,000-square-foot speculative office-to-medical conversion in Oakland, Calif., in March. Located near the hospital-heavy area referred to as "Pill Hill," the sale featured non-recourse debt and leverage of 65 percent.

I continue to hear from lenders that they're still “open for business for the right deal," which must be a euphemism for only wanting unicorn projects. Our experience is that most lenders are pencils down — and that our Oakland deal would not be possible today. The turmoil in the debt markets is also creating an ever-widening bid/ask spread.

When you overlay the Federal Reserve's hawkish stance, fear of expanding cap rates and seller expectations, it's extremely tough to get deals done. We have a saying around the office, “six is the new five," which refers to cap rates and the fact that they have expanded by at least 100 basis points.

Developers have to cast a much wider net to find debt. The institutions willing to lend are scrutinizing every aspect of the deal, which is a marked change from historical norms. Lower loan-to-value (LTV) and higher debt service coverage ratios, along with higher debt yields and rising interest rates, are the new reality buyers and sellers must wrap their heads around.

A Wall Street Journal article from July entitled, “Real-Estate Deal Making Slows as Bank Lending Tumbles," quotes Manus Clancy, senior managing director of data firm Trepp, as saying, “banks are exceedingly cautious right now…they don't want to get caught with their pants down." This sentiment has been echoed by the leading capital markets brokers and lenders focused on the healthcare space. We have recently had BOVs (broker opinion of value) done for some of our assets, and this credit tightening has negatively impacted those values.

Providers Slow Growth

The uncertainty surrounding capital markets and the broader economy is affecting healthcare providers' decisions. In a normal environment, we would say that providers move at a “glacial speed" yet, somehow, they have managed to find an even slower speed! Of course, it doesn't help that many major health systems have depleted much of their cash reserves accumulated during the pandemic.

The labor challenges — availability and cost — are dramatically impacting operations. A February article by GBH News in Greater Boston quoted the American Hospital Association as saying that high labor costs and nursing shortages are threatening to push many hospitals closer to their financial brink.

We are seeing good leasing velocity in our multi-tenant, ambulatory-outpatient projects with smaller practitioners and regional groups or specialists that all have a health-insured population. The larger systems seem to have an interest in this type of offering, but are reluctant to commit.

Inflation

Fed Chair Jerome Powell and some of the leading economists were saying last year that price increases and supply chain disruptions were just “transitory," aka — not permanent. Much to the chagrin of the American people, this view was incorrect.

You can't escape the daily barrage of headlines talking about inflation and the Fed's hawkish stance to try to reign it in. I would be remiss if I didn't mention the impact this has had on healthcare real estate. The increases and volatility in commodity pricing, the lack of skilled labor, and the supply chain issues are making it extremely difficult to pin down the timing and cost of tenant improvements, let alone something more complex like an office-to-medical conversion.

The current environment requires collaboration with all the stakeholders involved in a project — the providers, architect, general contractor, key subcontractors, material suppliers, lender and consultants — to make a deal pencil for all parties involved.

Labor Shortages, Supply Chain Issues

I recently listened to a panel discussion at the InterFace Healthcare Real Estate national conference that involved Mike Conn, Meridian's Chief Development Officer, and his peers from NexCore Group, Pacific Medical Buildings, Hammes Partners and Catalyst Healthcare Real Estate. They lamented rising costs, labor shortages and supply chain disruptions. Panelists discussed long lead times on items like HVAC equipment and electrical panels, which have to be ordered well before the building design was complete if they want to meet the delivery schedule. Luckily, none of the participants could point to a deal that died due to these challenges.

Still, there have been some very difficult conversations, and all stakeholders must be willing to roll up their sleeves and find solutions without compromising quality. Many projects can take upwards of a year to put together as you negotiate the purchase agreement, work through entitlements and finalize a lease with the user. Healthcare providers want to know upfront what their rental rates will be, even if the project won't be completed for two years.

We are seeing providers open to implementing Target Value Design (TVD), which is a radically different approach to the traditional way of designing and building facilities. Instead of treating the cost as the outcome of the design, TVD makes the cost and time constraints drive the design process, ensuring a new facility can meet the provider's schedule and budget.

Outlook

I am an eternal optimist and believe the current market dislocation will result in opportunities. While there are threatening storm clouds on the horizon, some potential outcomes and opportunities are:

• Land sellers capitulate and drop prices, meaning that we can provide great sites of care at a reasonable cost, lowering rent for the providers. This would help us deliver greater access to care and increased efficiencies for providers.

• Office buildings lose so much value that it makes economic sense to repurpose these buildings on a wider scale.

• Over the past several years, there has been so much capital chasing deals that value-add properties have been priced at core-plus returns. With the current economic headwinds, pricing is coming down. Those deals are now priced at a more appropriate risk-adjusted return. If the Fed is doing its job, we could see a decrease in demand that will lead to greater availability of construction materials and less price volatility. This will allow us to better pinpoint delivery timing and rental rates for our provider clients.

Developers and investors with healthy balance sheets and access to debt will have a competitive advantage.

Source: https://editions.mydigitalpublication.com/publication/?m=58491&i=767620&p=1&ver=html5