Is LA County’s Medical Real Estate Market Heading for a Correction?

A correction in the medical office market may be looming, but is there cause for concern?

The Fed increased its overnight lending rate to 2% in June yet sent mixed signals to the market when it left the Federal Funds Rate unchanged in its July meeting. The consensus is that a rate hike to 2.5% is coming within the next year. 

How does that influence healthcare real estate investors in the Greater Los Angeles area? With healthcare ETFs such as XLV on a continuous uptrend since April 2018, is the stock market sending early warning to real estate investors that it’s time to play defense?

Not so fast. 

An excellent research article by Paul Mouchakkaa’s (CalPERS Managing Investment Director, formerly Morgan Stanley) explains there is no statistically reliable correlation between interest rates and real estate prices. His assertion flies in the face of traditional investment dogma that interest rate hikes have a snowballing effect on cap rates, which, in turn, lower commercial real estate prices. The article suggests that credit availability, strength of demand, and inflation are more important factors impacting CRE prices than interest rate increases alone.

So, where is the medical real estate market in Los Angeles headed?  Here is what we see:

  1. Credit Availability: 100% financing is readily available for real estate and medical practices. Underwriting is more cumbersome than it was a decade ago, but SBA financing for properties is generally not a problem. 

    Practice financing may be a challenge. Lenders rely heavily on business appraisers who prioritize on cash-flow and EBITDA multiples without visiting the practice or interviewing doctors.  They also ignore the FF&E of the practice.  My experience as an appraiser has been helpful in communicating with underwriters and review appraisers to help doctors secure practice and real estate loans to complete acquisitions. An experienced mortgage broker is also a strong asset for a smooth transaction.

  2. Insurance Reimbursement Rates Drive CRE Prices More than Interest Rates: It may seem counterintuitive, but it is the decline in reimbursements that motivates doctors, IPAs, medical and surgical groups to grow revenues by expanding to new locations.  However, declining profitability puts a cap on how much a medical group can afford to pay to lease or acquire a new location. Demand for reasonably priced medical office space continues to thrive and may be enhanced by medical groups being awarded insurance contracts for new territories.

  3. Strong Demand for Medical Properties Under $3M: Most purchase interest comes from small-scale private investors (often 1031 exchange) or from developers looking for value-add opportunities. Medical users typically lease rather than purchase.

  4. Very Strong Demand from Institutional Investors: Demand for well-located Medical Office Buildings (MOB) over 30,000 SF close to major hospitals or medical schools with stable cash-flows remains very strong. REITs, Pension and investment funds also show strong interest in the ‘recession-proof’ areas of Santa Monica, the Beverly Hills Golden Triangle, Century City, etc.

  5. Tepid Demand for Non-Institutional Product: The demand is more measured in the middle range of non-institutional products, roughly from $3M to $15M. 

  6. Speculative Developments: Several developers are willing to roll the dice on well-located, speculative MOB projects. The majority still prefer opportunities at least 50% pre-leased. 

  7. Moderate Concern Over Interest Rates: Inflation expectations are measured as the Fed is implementing a less hawkish interest rate strategy.  

  8. Minimal Demand from Individual Physicians: Despite the numerous tax benefits of building ownership, individual doctors and medical groups often lease space.  In our view, this is a mistake.  As a general guideline, when a medical practice stays at a location for 10 years or more, they would benefit greatly from owning the real estate, instead of signing long-term leases with 3% + yearly increases and a much higher jump in rate at renewal. 

  9. Resurging Demand from Specialists: Strong demand from traditionally profitable specialties tapered off since 2010, however, we see it returning at a measured pace.  Most demand appears from pain management, orthopedics and vascular groups. A developer client reports that he recently signed several new contracts with plastic surgeons. These trends need to be balanced against cuts in out-of-network reimbursement rates and pending legislation impacting personal injury claims. Demand from well-priced dermatology and dental practices is very strong.  

  10. Lackluster Retail to Medical Conversions: Los Angeles does not seem to be embracing this much heralded national trend. On the contrary, we received competing offers from developers to convert former medical buildings to grocery stores and restaurants.

So where do we go from here? As the above graph shows, Medical Real Estate prices have risen steadily over the past six years and are currently at their peak. Traditional real estate cycles last 6.5 years, and economists agree that a market correction is overdue. At the same time, the Atlanta Fed recently estimated 4.8% yearly growth, which represents the strongest economic confidence since 2005. This confidence level suggests that the looming market correction maybe be relatively modest. 

Full employment contributes to heightened demand for traditional office space in Los Angeles. Meanwhile, the medical real estate market is preparing for the ‘silver tsunami’ of retiring baby boomers, by developing large medical office buildings in select locations. The recent uptick in rates by the Fed did not slow down investor demand for healthcare real estate in Los Angeles, and the additional 50 bps increase in interest rates may only have a limited impact on prices.     

However, we have seen early signs of a market cool down that have not shown up in prices yet. As the above chart shows, the volume of healthcare real estate sales is down, while prices continue to increase.  This may be a warning that reluctant sellers are having a hard time finding replacement properties.  Further, the bond markets also sent an alert with the flattening of the yield curve.  The promised additional rate hikes may push the curve to an inversion point that correctly predicted the last 7 out of 8 major recessions.  Nevertheless, appetite for quality medical buildings continues to grow as investors appreciate the safety of high-quality, long-term medical leases with market-based renewals and yearly increases to protect against inflation. The long-awaited market correction will likely arrive in the next couple of years; however, barring any major geopolitical event, it will probably be minor compared to the Great Recession of 2007.

-Steve Body, Vice President

Steve Body serves as Vice President at NAI Capital in Encino, Calif. He specializes in medical office properties, industrial, retail and investments. Mr. Body earned advanced degrees in finance and has analyzed over $6B in institutional and private real estate investments for some of the largest banks and investment funds in the nation. He can be reached at (818) 905-2400 X 1638 or sbody@naicapital.com. Cal Dre License #01927373.