A Healthy Real Estate Sector

Medical Offices: The Next Emerging Commercial Real Estate – Torto Wheaton Research (CBRE) – Yili Dolan, Senior Research Analyst – 15 August 08

With demand for medical services growing, there is also increasing dissatisfaction among patients, government officials, clinicians and healthcare executives. Out-of-date equipment and inadequate space in healthcare facilities are the top two issues. The space problem provides a compelling argument for a non-traditional type of real estate investment.

Looking at U.S. demographics, a growing number of developers and investors have determined that investments tied to healthcare are an attractive opportunity. Baby boomers represent 26% of the U.S. population and, now hitting 60, will place tremendous demands on Medicare and require a good deal of support from professional caregivers. In addition to aging baby boomers, the fundamental change in the way healthcare is delivered is the other demand driver.

By U.S. Census estimation, by 2050 there will be more than 85 million people aged 65 and over. Needless to say, such this should create a bright future for medical office development and investment. As demographics shift, many hospitals, research facilities and other elements of the U.S. healthcare sector have gone into expansion mode.

Investors can service the real estate needs of the healthcare sector in a variety of ways, with projects ranging from medical office buildings to biomedical research facilities to nursing homes. Additionally, demand for health services is highly inelastic and, with a high degree of government funding in the sector, there is more certainty in the income this sector can generate when compared to other potential tenants.

Due to the slowdown in the economy and the uncertain business prospects facing many tenants, the outlook for commercial real estate performance has been falling in recent quarters. Real estate investment tied to healthcare, however, has been relatively unfazed by these developments and the demand for new space remains healthy.

That demand for space in the healthcare market is strong should not come as a surprise; in the last 7 months the overall economy has shed jobs while healthcare employment has continued to expand. Furthermore, growth in healthcare employment is forecast to average 2.5% per year for the next 5 years-160 basis points (bps) higher than overall employment growth. As healthcare job markets remain strong, the assumption is that the requirements for medical space will be strong as well.

Employment Growth-Health Care vs. U.S. Total Jobs
Source: Economy.com.

That strong performance in healthcare jobs will lead to increased demand for healthcare-related space is still a hypothesis that cannot be fully tested. The issue is that there is still very little in the way of performance metrics for real estate tied to healthcare activity. There has been discussion among NCREIF members with an eye toward pooling their accounting numbers and introducing a new index of the performance of healthcare-related properties. The market will need to wait until enough investors are active in these property types, however, for performance statistics to become available. One indicator of activity available today, though, is the pace of development.

With the TWR/Dodge Pipeline database, one can track trends in the projects underway for a variety of commercial property types. Medical office buildings, for example, are one sector of emerging interest that investors have targeted to capture the economic potential of our growing need for healthcare spending. Very much like traditional office buildings on the outside, medical office buildings will typically have custom fit-outs designed to meet the specialized needs of medical tenants, which typically exclude this asset type from the leasing surveys of commercial real estate brokers. We can see, however, that the trend in construction activity in the medical office sector is at odds with that of more traditional office buildings.

Pipeline of Projects Underway-Medical Office vs. Traditional Office
Source: TWR/Dodge Pipeline.

Following the pullback from the lows of the Internet bust, the inventory of traditional office buildings underway grew from 2005 through 2007 as the sector recovered from a period of weak demand and high vacancy. Projects underway for the medical office sector, however, had experienced no substantial pullback. With ongoing healthy demand in the sector, developers continued to see projects pencil out favorably. The quantity of space underway has grown for both types of office space since 2007, with expectations for continued growth leading developers to take on more risks. One can see, however, that in the 1st quarter of 2008 developers pulled back from the traditional office sector. This was for a variety of reasons, ranging from stricter capital requirements to waning demand for space. Medical office development has not slowed, however, with enough ongoing demand to absorb new supply.

The solid economic and demographic stories that underlie the healthcare sector make it likely that in the future, more institutional investors will conduct objective analyses of the performance of healthcare-related real estate. As more investors dip their toes into this sector, more performance data will be generated, allowing for even more analysis of the drivers of performance. Such a virtuous cycle will help to increase investment allocations to healthcare-related real estate over the long term; however investors would be advised to start thinking about this sector for the near-term. The simple fact is that, in the face of a broader economic slowdown, growth in healthcare-related jobs stands out as a beacon of strength.