Seven months into working at home and the COVID-19 pandemic, healthcare real estate investments and developments are providing some evidence of trends that appear to be here for a while.
Aggressive Cap Rates
The healthcare real estate (“HCRE”) market is small compared to other sectors, yet there is a continuous flow of capital coming into it. The capital chasing deals in the market is particularly coming from private equity and private buyers. Yet the flow of institutional capital has a big impact on where cap rates are headed.
Since the start of stay-at-home orders, cap rates increased by approximately 50 basis points (bps) on multi-tenant medical properties, and a little more on single-tenant properties. With the obvious concerns, cap rates increased slightly in March and April, resulting in lower values. But now if there is high occupancy and good cash flows, pricing is back or better than pre-pandemic. No slow-down is evident for medical office buildings and ambulatory care.
Cap Rates Provided by Revista
Debt markets in March and April financed larger portfolios at lower leverage – a result less of COVID-19 and more of uncertainty in the market. Now most lenders are over that and leverage has increased. Lenders are financing single assets more often, things are getting more competitive with the availability of lower capital and construction loans are being done.
Signs appear positive, as private investors have a high rate of rent collection. Many tenants reached out for help at first and then realized they didn’t need it. Tenants became very focused on their cost structure which contributed to helping providers determine where they can find lower cost settings, what they can move off campus, and what service lines can be grown while keeping costs down. They became more efficient and cost safe than they had been previously.
At the start of the pandemic, the market wanted to know about rent collections from REITs. Several REITs provided consultants to their tenants/providers to guide them through applying for loans which offset deferred rent payments. It was a surprise that some REITs have maintained 99% of collections.
Overall, the percentage of rent collection is in the high 90’s. Lenders expect cash flow to stay positive and there will be plenty of loans, as people spend money when it’s inexpensive to borrow.
Healthcare providers have had capital plans for a long time, and they have had a chance to look at it closely to make sure they are spending money in areas that are most important to them. Sometimes that may mean spending money on things other than real estate, such as medical equipment, personnel, etc. Although providers have a need for capital projects, they also have capital constraints.
The development market is consistent with where it was last year, but the developers wouldn’t have said that in March or April. By early June they were back in operation and had made up what was lost earlier in the year. The ambulatory development pipeline is robust now, developers are bullish on 2021 and expect no major decrease in development activity.
Some non-traditional developers are looking to REITs for capital and expertise to help them deliver these medical property projects at lower delivery costs, while other developers are partnering with health systems and medical providers. The alignment looks like this: physicians want to be partners before even starting a development, but when it comes to writing checks, it is more challenging. The trend (looking at new assets) is that more physicians are getting out of real estate by doing sale-leasebacks.
REITs are making physician involvement available if they want it, but that interest goes up and down. Much will depend on what happens with the economy and how physicians view it, as the ability to be entrepreneurial is most important to providers. Physicians and developers must be aligned on their strategy, direction and long-term plan for it to have a great outcome and the partnership must understand what the physician group needs to translate it into something that economically makes sense.
Health systems have always looked to offer physicians the ability to have a long-term alignment with the system by investing in the real estate. With hospital involvement, the union must also deal with regulatory aspects like Stark Law compliance, and flexibility is key with physician ownership.
Often co-investment in a project helps a health system attract physicians to align with them. It also helps to bring the right mix of services to a building. Ultimately, the most important aspect is the cohesiveness of the building and the asset as a whole, delivery of modern healthcare, leveraging operational efficiencies, and synergistic relationships inside the building vs. just the investment piece.
The partnership percentage is still a minority position for physicians and is more of a tax discussion with physicians rather than how long the investment will be held. Physicians own typically 15-30% of the asset, although occasionally with a very strong tenant, there may be a 50/50 split. Also, some physicians want to invest, who aren’t tenants in the building. This is often seen as a negative by some developers.
When developing new projects, not-for-profit hospitals are expecting minimal spread between takeout cap rates and development yield, which is a challenge for developers. They went from 200 bps spreads to 25 or 50 (available private capital has different expectations). Hospitals will find that it is important to look for value and they will benefit from avoiding the lowest cost of capital vs. searching for the highest quality of development.
Disruptors that Impact Investment Strategies
COVID-19 has definitely been a disruptor, and in some cases, it has accelerated providers’ cost structure, forcing them to go off-campus more rapidly than was occurring before this event. Working on social distancing and curbing the spread of disease, most have set up waiting rooms that are smaller, and providers are using apps for patients to wait in parking lots before going to an exam room. Physicians and health systems are trying to determine how the common layout of a clinic or hospital, that we’ve used for the last 10 years, can become more efficient and safer. It has been suggested that retail similar to IKEA stores may have a good idea – providing a one-way path in and another way out. New technology is being implemented in new ambulatory layouts and it’s important that providers buy in and continue to do things in the safer ways that were created and achieved during the pandemic. The healthcare consumer wants to see people cleaning the space, not just signs that it was cleaned. Telehealth is a great addition to healthcare and although it’s not seamless yet, it’s being figured out. Telehealth opens a whole other avenue for seeing patients that wouldn’t normally be seen and assets may shift to more specialized buildings including surgery centers, ENT clinics, orthopedic facilities, primary care offices, and some exam rooms will be set up for both in-person and telehealth.. No physician will do only zoom calls, physicians like to spend time with patients and have in-person interaction.
Overall, trends point to better conditions for patients, and creative opportunities for providers. Investors continue to see healthcare real estate as a safe harbor and strategic investment, particularly when interest rates will stay low for the foreseeable future.