Medical-Office Sector Leans on the 'Master' Lease

By Dow Jones Business News, 
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By Matt Hudgins

PEARLAND, Texas--The medical-office sector is undergoing a broad transformation with the rise of master leases.

In those deals, a large company or organization leases several floors or an entire building, then typically sublets the space to smaller users. Until recently, the sector had relied on myriad small leases backed only by the guarantees of individual physicians and small practices.

Just this summer, construction kicked off on a proposed medical office building south of Houston after hospital operator Memorial Hermann Health System agreed to lease more than one-third of the building. HCP Inc., a developer, is building the project on Memorial Hermann's campus here, where the hospital system already has a master lease for an existing 80,000-square-foot office building.

Marshall Heins, Memorial Hermann's head of facilities, declined to disclose the terms of the lease or the rent it will pay for the new space. In general, he says, rents are climbing rapidly and property values are eclipsing those of conventional office spaces.

"Medical-office lease rates continue to rise across the country," he said. "This is probably the hottest sector right now."

The deal is an example of a side effect of health-care reform some might not have expected. Across the nation, the value of medical office space is skyrocketing as the size and credit quality of tenants increase.

In the past, many medical offices were leased by individual doctors and small practices rather than by large, well- funded institutions. In an exodus that began in 2009 and accelerated under the Affordable Care Act, many physicians are abandoning the independent-practice model to join large systems that are better able to create efficiencies and control costs.

For example, the Affordable Care Act requires health-care providers to maintain digital medical records by 2015 or lose progressively larger percentages of Medicare reimbursements each year. At Memorial Hermann, doctors to whom the company leases space will have access to Memorial Hermann's digital-medical-records infrastructure, as well as optional services in areas such as reception, billing and office management. Those doctors, in turn, are expected to steer patients to the system's hospitals.

Master leases such as the one signed by Memorial Hermann are becoming the norm at medical office buildings, boosting property values and investor demand for the asset type, according to Eric Johnson. Mr. Johnson runs a group that advises health-care companies at Transwestern. The Houston-based commercial-real-estate firm markets HCP's building for lease and brokered the recent deal with Memorial Hermann.

"The beauty of these master leases is that now we're not doing 2,000-square-foot deals. We're doing 30,000- to 50,000-square-foot deals, " Mr. Johnson said. "For a developer, with one lease, you can hit your minimum pre-leasing requirements required by the lender for construction."

Memorial Hermann previously owned its office buildings and leased directly to tenants. About five years ago, it sold those properties and leased them back in order to free up cash for other purposes. "With health-care reform, we spend our dollars where we get a better bang for the buck," Mr. Heins said.

The new economics of the industry have also led to strong demand from investors who want to own medical office buildings. Some 822 properties with a collective sales volume exceeding $8.2 billion changed hands during the 12 months that ended June 30, a six-year high, according to New York researcher Real Capital Analytics. Median prices on a 12- month rolling average reached $229.67 per square foot in the past 12 months, the highest since early 2008, Real Capital found.

Asking rents for medical offices average $23.36 per square foot currently in Houston, according to CoStar Group, a researcher. That is up 4.9% from the $22.27 recorded in the fourth quarter of 2010 and exceeds the previous high of $ 23.08 set in the first quarter of 2009. Yet rent growth alone may not account for the steeper uptick in acquisition prices.

Some observers attribute the increase to the relatively low risk associated with health-care systems as tenants. " The institutional capital has seen this transfer of credit from individual practitioners to, now, bonded hospitals that have institutional credit," Mr. Johnson said.

Properties leased to pharmaceutical companies, which also are generally seen as having a relatively low risk of defaulting on a lease, increased values for landlords during the 1990s, points out David Rodgers, a research analyst at Robert W. Baird & Co. "You went from these lower-value buildings to an asset class that became somewhat sought-after, and credit has a lot to do with that," Mr. Rodgers said. "We are seeing that very same trend, the move to credit, occur within the medical-office field."

Wunderlich Securities Inc. research analyst Craig Kucera argues that, more than credit, rising values reflect low interest rates and potential rent growth as large health systems take up more of the market's rentable space. "These large physician groups are thriving," Mr. Kucera said.

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This article appears in: Real Estate

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