In commercial real estate, there are generally considered to be four asset types: office, retail, industrial, and land; however, there are subtypes or specializations within each that have their own unique characteristics. One example is flex space. Flex properties are unique because they are a combination of office and warehouse; not to be confused with one-story office or industrial with a small office component. Another example, and the subject of this article is medical space. While traditionally falling under the office category, the desire for visibility and “walk-ins” have led to an increase in the number of doctors and dentists locating their practices in retail spaces. There are specific features of medical space that differentiate it from typical office use and impact its appeal from a landlord/investor perspective.
There are many different medical specialties, but the most important characteristic of medical space that distinguishes it from general office space, from a commercial real estate perspective, is how the space is used. Normal office space is for the use of the tenant and its employees with the occasional visitor or guest. Medical space, on the other hand, is used by the tenant, its employees, and patients. This is significant because of the increased traffic and resulting wear and tear on the building’s common areas. Furthermore, tenants (and their employees) of a building have an interest in taking reasonable care of the common spaces (particularly bathrooms) because they work there and use the facilities every day. Patients and visitors do not*. They may visit the building once or twice per year and, therefore, care little with how they leave it (testing centers are particularly notorious in this regard). Depending on the size of the practice, number of practices within a particularly building, and the number of daily patients, landlords may incur significant costs by having to renovate the common areas to maintain the building’s quality and with greater frequency than its nonmedical counterparts. This causes many landlords, particularly of Class A buildings, to institute a policy of no medical tenants in their building.
*Many medical offices have bathrooms within their space for the use of their employees and patients, and while this may be their decision based on the nature of their practice it may also be a requirement of the landlord to minimize wear and tear and disturbance of other tenants.
A distinction does need to be made between both single-tenant (individual condo) and multi-tenant properties and then again between office and retail space. As mentioned, the wear and tear on building common areas is the main reason that medical use is seen as undesirable. This issue is magnified in multi-tenant office buildings where common areas are shared, and particularly in multi-story buildings in which the medical tenant occupies space on any floor above the first. For single-tenant office properties (usually smaller) where a medical tenant occupies the entire building, this issue is mitigated to the point of elimination. In these situations, the tenant’s use is factored into the deal, mostly likely through a triple net rental structure where the tenant is responsible for paying for maintenance, repairs, and replacements of common areas and building systems. This leads to the subject of medical use in retail space. Most retail spaces are self-contained units with their own entrance and building systems. The common areas are relegated to the parking lot, sidewalks, etc. and retail landlords account for and want as much traffic as possible. Like single-tenant office properties, they mitigate their exposure to the externalities of medical space through a triple net rent structure.
Apart from this adverse aspect, medical tenants are some of the most desirable from both a landlord and investor perspective for two main reasons: 1) they sign long-term leases and 2) they are considered to be among the most stable/least risky businesses from a financial standpoint. Due to the significant capital investment required to build out medical space, doctors and dentists prefer 10-year (plus) leases with renewal options, typically two 5-year terms for a total of twenty years. This gives them a longer period over which to amortize their costs. Medical practices also benefit from the sense of familiarity and permanence that remaining in the same location instills and which also allows them to add to their patient base over the years. In addition to the capital cost of moving and constructing a new office, medical tenants also risk lost revenue from attrition.
Healthcare spending now accounts for nearly 1/5 of our gross domestic product and, as more states implement Medicaid expansion and baby boomers continue to retire, we can expect that number to rise (healthcare spending on average nearly doubles after the age of 64). Medical practices have always been seen as stable businesses though. Doctors and dentists have specialized skills that are always in demand. Just like you can’t fix your own car (anymore), you don’t want to perform surgery on yourself and, unlike automotive problems, serious health issues are not something you want to put off addressing. Even in 2008 and 2009, when the economy and lending ground to a halt, banks were still lending to doctors and dentists and, today the rates offered to medical practices/practitioners are among the most aggressive out there (even to the point of 0% down and rates around 4% or lower). This provides a vital insight into how medical practices/tenants are viewed from an investment standpoint. The process by which landlords evaluate tenants is similar to the underwriting process for financial institutions. Instead of lending money, the landlord is lending the tenant use of their space and, thereby, foregoing income from other potential tenants. The more stable the tenant, the greater the likelihood the landlord will receive the agreed upon income stream over the lease term, and the less risky an investment the more an investor is willing to pay for it. Landlords are investing in their tenants and thus are willing to make greater economic concessions to secure them as a tenant because they are confident that they will make that money back over the term of the lease and/or based on a sale of the property.
Another element of medical space that contributes to its security from an investor/landlord perspective is the large capital investment made to construct the premises and the resulting infrastructure value. Medical build outs have never been inexpensive but with rising labor and construction costs they can reach $150+/SF. Depending on the rental rate and tenant’s financials, landlords may be willing to contribute a sizable tenant improvement allowance, but one that is still unlikely to account for even half of the required capital. Tenants that invest their own money in a space have an interest in that space; increasing the likelihood of remaining/renewing in place and decreasing the likelihood of default. In the off chance a medical tenant defaults, vacates, or relocates, the landlord is left with an extremely marketable space with valuable infrastructure (and potentially equipment). Most medical practices have similar layouts (waiting room and check-in/check-out area, exam rooms with sinks, etc.) that can easily be reused by other specialties (doctors and dentists). Medical tenants can save hundreds of thousands on build out; allowing them to deploy capital elsewhere. As a result, landlords may also be able to charge a premium for medical space thus increasing the property’s net operating income and market value.
As discussed in previous articles, cap rates provide an estimate of property’s value based on its net operating income. They are expressed as a percent because they reflect the rate of return (based on an all cash purchase) that an investor is willing to accept for the year-one income stream. Market cap rates are calculated by analyzing sales comps based on property type, class, size, etc., but acquisitions are truly made based on the discount rate an investor places on the property’s future cash flows. Discount rates include a risk premium which can either increase or decrease the acquisition cap rate thereby lowering or raising the price, respectively. Secure investments require a much lower return (think Treasury bonds). While there are many factors involved in a risk assessment, the probability of tenant default and length of lease term are among the most important. If a tenant defaults the landlord must incur legal fees, lease-up costs (brokerage commissions, improvement allowances, etc.), and vacancy losses. Similarly, assuming the tenant does not default, the remaining lease term, better expressed as the remaining future cash flows, is the only income stream that the purchaser can rely on with relative certainty; being unable to predict future market conditions (vacancy rates, rental rates, etc.). The tenant may renew but it may also be the case that the owner is required to find another tenant, thereby incurring the aforementioned transaction costs and vacancy losses. Medical tenants minimize these risks through all the reasons mentioned and ask a result, landlords/owners are able to sell their leasehold interests at a premium; increasing the sales price relative to an equal but considerably riskier rental income stream.