We are getting insights in the medical office space from Catherine House, she is the National Healthcare Chair for the firm SVN. She is responsible for coordinating healthcare related commercial real estate activities in medical and dental office buildings, and seniors housing throughout the company. She is particularly known for her experience in the acquisition and disposition of medical and office buildings, medical condominiums, and neighborhood commercial buildings in Northern California.
Tell us a little bit about you.
I am the SVN National Healthcare Chair of the 1600+ commercial real estate brokerage firm. And as the chair, I’m responsible for coordinating the healthcare related commercial real estate activities within the company. In 2010, the San Francisco Business Times named me one of the most influential women in business in the Bay Area. I am a CCIM, which is conferred upon commercial real estate leaders with a proven record of success in the field, as well as mastery of financial market and investment analysis.
The medical office space is super interesting and there are all kinds of ways to add value. But first, why don’t we start with what is going on in the overall office space nationally.
This has been a particularly tough time for the office market. What we’re seeing is the Coronavirus pummeling the US office leasing market activity in January of this year. It’s literally 44% down from a year earlier. We are in an unprecedented time. We have many companies trying to aggressively reduce their office footprint. And we’re seeing this in particular in large urban markets. I think what’s interesting for people to look at is what’s happening with shadow space. It’s very much the canary in the coal mine in the office sector. So keeping an eye on sublease space in your respective market is a way to keep an eye on what will be happening.
Sublease space nationally, is now over 192 million square feet. That represents a 55% increase from the first quarter of 2020. It’s extraordinary numbers. Commercial real estate does not usually move particularly quickly. And this is really quite unprecedented. The first quarter of 2021 obviously isn’t over yet. We’re barely towards the end of February. And it’s too early to declare a trend. The pace of subleasing activity did moderate recently, and that’s nationally. If you actually look at the urban tech hub, such as San Francisco, in California, which is actually where I’m based, as well as Seattle and Austin, they have seen a dramatic increase in subleasing. So I think the national trends may be showing one direction. But I think as you go in and pinpoint in individual markets, there’s a huge degree of variation. And a lot of these very strong core markets are really struggling. Even Chicago, not known as a tech center, like Silicon Valley has seen a huge jump in subleasing. And that may well be because they have a fair number of major tech firms in their city. The vacancy rate in San Francisco is currently at 11.5%. But I think what’s interesting is, when you look at the forecast of what’s going to be happening, we’re predicted to actually have a vacancy rate of close to 18% by the end of the year. And so that has huge repercussions to rental levels and building values.
And I know that before COVID, we were at an unprecedented low vacancy rate. I don’t recall the exact number, but it was something around three to 4%.
It depends on where you’re looking, in San Francisco, our vacancy rate was significantly below the national average. We went from a period of of being below 6%, for office, to now being close to 18%, depending on which economists you are looking at, and also the quality of the real estate, are you talking about Class A, B, and C? Exactly where is it located? So there’s a number of different variables.
Let’s dive in and focus on the medical office space. Doctors are back and they can be in their office seeing their patients. How is that space looking nowadays?
Coming into last year, there seems to be no question that total sales volume in the red hot medical office building sector was going to surpass the annual benchmark of $10 billion that we’d seen before. And then all of a sudden, the COVID19 pandemic struck. And that really made 2020 a very interesting year when you couldn’t take anything for granted. Good news, it can now be declared official from multiple sources. MOB sales actually topped over $10 billion for the seventh straight year. And depending on your sources it topped $11 billion. And so it’s a very different story than the one we were seeing when looking at traditional office space.
And I know a few people that love the medical office space. Can you share a little bit about why they are so popular right now? And what’s happening in that space that it’s becoming so hot? In a similar way to the industrial space.
1. For those people who are looking for safety, and I think there’s an element of a flight to safety for people who are interested in this sector, if you’re looking for distressed asset opportunities, this is probably not going to be the right sector for you to be focusing on. There’s a number of reasons for that. And if you actually look at the Medical Office fundamentals, there’s some really interesting trends. If you look at rent growth, for example, I’m specifically looking at hospital affiliated medical office, the average rent continued to gradually increase throughout 2020. And they’re predicted to continue increasing in 2021. So the national medical office rent is currently approximately $26 per square foot. And we’ve positive rent growth, currently at less than 2% nationally.
2. The other fundamentals to look at is occupancy. Occupancy for on campus is currently 93.3%, and 92.6% for hospital affiliated off campus medical office buildings. And that’s according to the industry source Revistamed is one of the main industry sources of information for the medical office sector. They have a great website, I would encourage anyone interested in this sector to check that out. The other really good source for information if you’re interested in this sector, which is a little more difficult to find information on, is Real Capital Analytics. I would encourage people who are interested in more information to look at those two sources. Occupancy trends have been very steady. And they’re actually forecast to remain steady throughout 2021. If you compare that with our predictions that we were just talking about for regular office, we’re talking about very stable metrics with vacancy below 10%, and predicted to remain below 10%.
3. The other thing that we’re seeing is absorption rates are outpacing completions. If you look at cap rates, another great fundamentals to take a look at, we actually saw them decline in 2020. And declining cap rates, and steady rents actually mean an increase in the underlying value of the assets. So, based on RCA’s data, the quarterly average MOB cap rate actually remains between 6.3 and 7%, since the beginning of 2015. So it’s steady, it’s safe. For investors interested in a safe steady investment, this particular sector was getting a lot of interest.
What is driving all of that demand?
1. One of the key reasons is that medical office is an essential sector that really remained open for business throughout the pandemic.
2, It’s also an area where it is extremely difficult to do it remotely. For the most part, if you need to see your physician, you need to physically go into the office. Whilst there has been an uptick in trends, such as telemedicine, which is a very fascinating area to get into that I’m not sure we have time for today, in general, there is still that demand for in person visits.
3. And many physicians did have their income impacted in 2020, one of the reasons for that is a lot of the elective surgeries and procedures that are actually the most lucrative, many people actually put those off. So the revenue for the year and 2020 was down.
4. But in the long run, that businesses survived and actually are predicting to be extremely busy in 2021 and beyond.
5. And that’s not even getting into some of the demographic trends that we’re seeing with the aging baby boomers. There’s a correlation as one gets older for an increased need for medical services. So we’re actually expecting the demand for medical office to continue to grow significantly over the next 10 years plus.
Is it safe to conclude that you don’t foresee any foreclosures or any special deals in that space coming up?
I am not expecting to see many foreclosures in this particular sector. However, what I would say is to look for discounted transactions, rather than waiting for foreclosures. And I think there’s also an element of consolidation. What I would encourage people to do, if you’re interested in a particular sector, is to speak with a commercial real estate broker in your individual market, because one of the great things about commercial real estate is it’s a very inefficient market. So you can be aware of the situation or a circumstance that will be causing a particular building to come on the market. And those inefficiencies actually mean that you can take advantage of some great opportunities that maybe are only known to a handful of investors. I think there are some great opportunities out there. But make sure you have a good team, have an attorney, have an accountant, have a broker and make sure that you’re looking into all of the variables, all of the tax consequences, and make sure that you’re really diligent, so you understand why that building is very interesting.
Is there anything else that you think is important for our audience to know?
I could actually probably pontificate for hours. I’m happy to talk on any particular segment of this that anyone would be interested to talk about. But it’s a really interesting area. And whether you’re looking at telehealth and its impact on bricks and mortar, whether you’re looking at where’s the best place to invest. You could actually spend a lot of time on that and there’s a lot of very interesting trends that are basically going to be coming to pass this year. So I think we are looking for a period now through the end of the year, where we’re going to see more and more distress. The medical office sector is going to be more immune to this than the office sector. But that doesn’t mean that they’re going to walk away unscathed.