For more information, please contact Hailey Johnston: hailey@chestnutre.com or 423.708.2178

Viewpoints

April 2021 - Why Medical Office Buildings

When we founded Chestnut Funds in 2012, our investment thesis was that opportunity existed in the middle market space to manage funds in an institutional manner but with a focus on assets that typically did not attract institutional capital. We focused on property types that we had first-hand experience with - office, retail, industrial, and medical office properties. During 2021, our Viewpoints series will discuss the property types that we invest in, outline some of the reasons we make these investments, and share our view of what the future might hold. In this first installment, our focus is on medical office buildings.

Chestnut made its first medical office investment in late-2012. To date, Chestnut has made 17 value-add, redevelopment, or development investments in medical office buildings out of Chestnut Real Estate Funds I, II, and III. Additionally, Chestnut co-manages Chestnut Healthcare Fund I and II with Anchor Health Properties. These two funds acquire core and core-plus medical office buildings and other healthcare assets. Investments in medical office buildings make up 70% of invested capital across all funds.

Our interest in medical office building investment is based

on several investment attributes:

 

1. The positive demand trajectory associated

    with healthcare services.

 

2. The supply-constrained nature of the sector.

 

3. The relatively recent acceptance as a stand-alone

     institutional asset class and the changing ownership profile.

The Demand Story

In the medical office building investment sector, it is a widely accepted that a growing and aging population increases the demand for healthcare services, which in turn generates demand for healthcare real estate. What is less talked about is the changing nature and location of the delivery of healthcare services.

 

 

 

 

Supply-Constrained Market

Building on the idea that modern, purpose-built facilities are in demand by healthcare service providers, the new supply of medical office buildings is typically in direct response to tenant demand with little speculative development. Moreover, as healthcare service providers move to new facilities, their former facilities are often deemed obsolete, limiting the asset’s ability to compete with newer space.

Beyond the fact that development is typically tenant-led, an additional factor limiting the supply of new medical office buildings is the relatively high cost of construction. Development costs of medical office buildings are typically higher than commensurate commercial office buildings due to the extensive tenant build out that is required. This additional cost, and the specialized nature of the space in which services are provided, limit new development.

Redeveloping underutilized commercial office or retail properties to become medical office buildings has the potential to add supply to the sector. However, our experience and that of others suggest that conversions are difficult. The redeveloped properties must be in appropriate locations, and the configuration must be suitable for modern medical facilities. While certainly there are excellent examples of medical office conversions, our view is that these are “needle in the haystack” and unlikely to significantly add to the supply of medical office buildings.

Institutionalization of the Medical Office Building Sector

From our perspective, as many of the favorable attributes of medical office building investment have become more well known, institutional investors have taken notice and are allocating larger portions of their real estate investment to the sector. It is our opinion that this has served to increase liquidity and to bring returns in line with class A office assets. Institutional investment in the sector comes from a recognition of the income stability, durability, and demand growth for healthcare services as well as the strong credit profile of the tenants that occupy space in medical office buildings. Institutional investment in the sector also assists in increasing liquidity, providing the opportunity for more efficient dispositions of assets - an important consideration for us as we underwrite assets for an eventual sale. These factors, combined with greater stability from the relatively lower correlation to overall economic activity than other real estate asset types, make the sector an increasingly attractive investment in our opinion.

Historically, many medical office buildings were owned by health systems, but that continues to change. Health systems increasingly see value in selling their real estate assets and are leasing space instead. We believe this is an attractive option for several reasons. One is that it avoids certain compliance issues related to leasing space to physicians affiliated with the health systems in medical office buildings that they own. Another is that health systems are able to reallocate capital from real estate to operational investments and physician recruitment.

Outlook and the Impact of the Pandemic

From our experience, the attractiveness of medical office building investment has drawn new entrants and capital into the sector, leading to lower initial yields on new investments. This has happened recently to some extent because the pandemic highlighted the resiliency of the sector. But as that has happened, asset values for existing assets have benefitted. Our view is that the fundamentals that have led to the current positive sentiments surrounding medical office building investment will remain in place for some time.

The COVID-19 pandemic is likely to change the way in which we live and work. While some property types, such as office properties, may see diminished or different demand, our view is that healthcare services will continue to be primarily delivered in an outpatient setting and in person. Telemedicine and other innovations will continue to develop, but we expect those to be a supplement to the traditional in-person services rather than a replacement.

Chestnut recently launched two funds that have exposure to the medical office building sector. Should you have an interest in learning more about either of these funds, please feel free to contact Steen Watson at steen@chestnutre.com or (423) 822-8761.

The information contained in this newsletter is intended for informational purposes only and is not intended to provide personalized investment advice or to constitute an offer or solicitation to buy or sell securities or interests in any investment. The charts, graphs, and other information contained herein should not serve as the sole determining factor for making investment decisions.

This newsletter cannot be reproduced, shared, or published in any manner without the prior written consent of Chestnut Funds (“Chestnut”). Unless otherwise indicated, all statements and expressions in this paper are the sole opinion of Chestnut and are subject to change without notice. Predictions, forecasts, or outlooks described or implied are forward-looking statements based on certain assumptions, which may prove to be wrong, and/or other events, which were not taken into account, may occur. Any predictions, forecasts, outlooks, opinions, or assumptions should not be construed to be indicative of actual events, which will occur. The opinions and data in this newsletter have been obtained from sources believed to be reliable. Chestnut does not warrant the accuracy or completeness of such and accepts no liability for any direct or consequential losses arising from its use.

Investing in securities involves risk of loss and should not be based solely on marketing materials including the information provided herein.    Further, depending on the different types of investments there are varying degrees of risk.  Private Funds managed by Chestnut Real Estate Funds and their investors should be prepared to bear investment loss, including loss of original investment. There is no assurance that any specific investment or investment strategy utilized by Chestnut will be either suitable or profitable for your portfolio.  Chestnut does not provide personalized or customized investment advice, therefor you are urged to discuss your personal investment situation with the financial professional of your choice before making or changing an investment in a Chestnut offering.

Because of the inherent risk of loss associated with investing in any type of securities, Chestnut Real Estate Funds is unable to represent, guarantee, or even imply that its services and methods of analysis can or will predict future results, successfully identify market tops or bottoms, or insulate you from losses due to market corrections or declines.  

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A focus on cost-containment has led healthcare providers to move the delivery of many services to outpatient settings, which are often located in medical office buildings. The profit margins for providers can be higher for outpatient services due to the lower cost structure these facilities offer.

Furthermore, medical office buildings are generally located closer to patients, a strategy that makes sense as health systems and physicians compete for market share. With locations near patients, medical office buildings have become the virtual “front door” to the hospital, spurring referrals. This transition to outpatient healthcare services has resulted in growing demand for modern, purpose-built facilities, driving value for assets that fit that profile.

Increased Use of Specialty Practices.png

In 2015, visits to primary care generalists, which include internal medicine, obstetrics and gynecology, pediatrics, and general/family practices accounted for 41% of doctor’s office visits, while visits to specialty care physicians accounted for 59%, a proportion that has steadily increased since 1980. As the industry continues to see increased use of specialty care, medical office buildings stand to meet this need through providing custom, state-of-the-art facilities purpose-built for specialized healthcare tenancy. 

Source: National Center for Health Statistics, National Ambulatory Medical Care Survey (NAMCS)