Medical office sector lures developers
These are interesting times in the medical office industry.
The sector has been a bright spot for developers and owners over the last 18 months, enjoying a pace of absorption and new projects that was sharply higher than in previous years.
Investors joined the good times, buying and bidding up prices on investment medical properties.
A prime example was last December’s sale of the 90,000-square-foot Centennial Lakes Medical Center at 7373 France Ave. The buyer paid $26.7 million — or $297 per square foot — for the fully leased building. A similar building in another prime suburban location, the Arbor Lakes Medical Center in Maple Grove, sold for $189 per square foot four years earlier.
Developers have announced plans for even more projects in the next two years, betting on the continuing strength of a handful of demand drivers — the health-care needs of an aging population, cheap credit, and the continued migration of the region’s population into second- and third-tier suburbs.
A reflection of that confidence, a United Properties tally of projects under construction or on the drawing board reached 1.7 million square feet early this year, almost one-third of the region’s existing supply of medical offices.
Still, industry watchers say the pace of development will probably slow in many submarkets as new buildings open and remaining space is filled.
“I don’t think that all of those will necessarily be built,” said Alex Young, vice president for development at MSP Commercial, one of the region’s busiest medical office developers over the last decade. “There’s going to be a slowdown in leasing as new projects open, and I think developers will take a little breather.”
Stephen Brown, vice president in the United Properties Healthcare Real Estate Group, agreed with that assessment, saying, “This market moves like lava.”
Part of the reason for the deliberate pace is higher-priced product. Medical buildings require costly infrastructure to support high-tech equipment; build-outs that are more detailed and parking requirements that exceed typical offices.
“That [higher price] means developers don’t have a lot of margin to play with, so projects have to be well thought out,” Brown said. “Savvy developers are going to say, ‘I’m going to wait until I get demand.’”
A development by St. Paul-based Suntide Realty is a case in point.
Suntide, traditionally a retail and office specialist, signed on with a landowner to develop 100,000 square feet of medical offices on a parcel adjoining the St. John’s Hospital campus in Maplewood.
But that project, announced some time ago and included in this spring’s bulging tally, doesn’t have a start date yet, said Suntide President Steve Dombrowski.
The project will almost certainly be health-care related because “that is the highest and best use of that site, adjacent to the hospital,” Dombrowski said. “But the owner is very patient on this property. We aren’t going to move until we have major tenants signed up,” he said.
Still market signals continue to beckon to developers.
Absorption of medical office space reached 216,000 square feet in 2006 — just a little less than the total in the three prior years combined — and absorption has stayed strong early in 2007. Grubb & Ellis/Northco’s first quarter report tallied another 67,000 square feet of absorption in those three months alone.
“I believe this year will finish strong, too, due in part to some of the larger new projects opening at 100 percent occupied,” Brown said.
The biggest test for that absorption pace will come in Maple Grove, where a tidal wave of medical projects is under way, thanks to steady population and commercial growth combined with the long-awaited approval of a new hospital.
More than 500,000 square feet of medical development was in the ground or planned early this year, with several other buildings already up and operating, according to United Properties.
The pace of development, led by Ryan Companies US. Inc.’s hospital partnership with North Memorial Health Care and Fairview Health Services, probably won’t slow, even if leasing gets soft.
“I think they’ve [Ryan] found the perfect storm there,” Brown said. “They’ve got a nice big chunk of land in a market where the demographics are very good.”
The quick addition of medical space could push Maple Grove rapidly from underserved to over-served, but tenants and developers are betting that, even if leasing starts slowly, their projects will succeed in the long term.
“They’re saying, ‘That’s OK. We can handle a ramp-up that takes a couple years. We don’t want to miss the opportunity to be here,’” Brown said.
Strong fundamentals — aging demographics and new homes — will continue to drive the sector elsewhere in the metro, but products will need to develop their own local stories.
Eagan-based MSP has a built up a portfolio of 14 medical office buildings, most of which are fully leased and were designed to serve either medical or general office uses.
The developer starts from a traditional approach, focusing on location, Young said.
“We look for high-traffic, very visible sites, always near retail locations. First-rate locations are the biggest thing for us,” he said.
MSP may have established that model, but much of the health-care industry has learned the lesson now, said Jill Rasmussen, a veteran health-care industry broker with Northstar Partners.
“I call it the ‘retailification’ of medical offices. Its whole aim is to be patient-friendly,” she said, noting the concept offers convenience to busy patients by linking the practice to the retail strips where they shop frequently.
The search for the right space often leads health groups to nontraditional properties — from retail strip centers to conversion opportunities in office or office showroom spaces.
Those deliver top-shelf convenience and visibility, but they also create a new dilemma: Build-out costs in those non-medical buildings run from $70 to $110 per square foot, a price few landlords are willing to pay, Rasmussen said.
Risks in off-campus
Those shifting industry strategies have added to leasing hazards that already cause headaches in the industry, especially for properties located away from the region’s medical campuses. Vacancies there are more than 14 percent and frequently higher.
“Those are finicky markets,” Brown said. “They’re niche-driven, and if you miscalculate by a little, you end up sitting on vacancies for a while.”
The need for developers to avoid missteps will grow as prices climb, from an average of $16 per square foot in 2005 to well over $20 for new buildings today.
Those costs give some existing building owners a pricing advantage, but they’re also driving some tenants to tighten their belts and reduce the amount of space they lease, Brown said.
One more wild card that could limit growth is the ability to hire new doctors, Brown said.
“They’re all asking themselves, how do we staff this ramp-up? It’s competitive, especially in the Midwest, so that’s something to watch,” he said.