MEDICAL OFFICE: Demographics Drive Long-Term Demand and Risk/Return Rewards

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1 MEDICAL OFFICE: Demographics Drive Long-Term Demand and Risk/Return Rewards October 2018 Webber Beall, Executive Vice President, Lincoln Harris CSG Brian Lantz, Vice President, Lincoln Advisors The U.S. population is aging rapidly, healthcare spending continues to increase well ahead of inflation, and healthcare needs are expected to expand at an accelerated pace over the next two decades as a result of the demographic trends. In the meantime, doctors, hospitals and insurers seek more streamlined costeffective, and profitable ways for delivering services, and increasingly are looking at real estate related solutions to help provide patient care. These dramatic trends offer opportunities for real estate investors to take advantage of growing demand for medical office space, which offers potential risk diversification beyond conventional office portfolio strategies as well as distinct core, core-plus, and value add investment options. As a non-traditional real estate asset class, medical office has gained significant recent institutional acceptance. In fact, the National Council of Real Estate Fiduciaries (NCREIF) is evaluating whether medical office should be included as a subcategory of office and become part of its NPI real estate performance index in early CoStar, the giant real estate market database manager, also has announced the pending rollout of a separate asset database devoted to medical office statistics. Given the late stage of the current economic cycle, now entering its 10th year since the last recession, medical office may stand to benefit from what we believe to be particularly compelling counter cyclical demand drivers, based on demographic factors and healthcare imperatives and not as much on pure economic fundamentals. These trends include: Healthcare spending is 18% of U.S. GDP and growing more than 5% annually, driven primarily by the large baby boomer demographic aging into a life stage of greater medical need; 1 The number of people age 65 or older will increase from approximately 49.2 million in 2016 to 94.7 million, or 23.5% of the U.S. population, by 2060; 2 Healthcare delivery has migrated to lower cost outpatient settings in attempts to reduce price inflation; 2 and Outpatient visits have doubled in the last 20 years and are expected to grow 20% in the next 10 years, increasing demand for new medical office facilities. Besides helping mitigate portfolio risk through exposure to counter cyclical demand drivers, medical office investments can help achieve competitive returns over the mid to long term as a result of its underpinnings in substantial demographic trends. SIMPLY DEMOGRAPHICS The case for medical office is compelling and straightforward due to population aging, healthcarerelated real estate could enjoy built-in, ongoing demand drivers. As a result, we believe many investors are realizing that healthcare real estate may be more stable and recession resistant than other commercial real estate sectors. The U.S. Census Bureau estimates the population aged 65 and above is expected to increase by 1.7 million (3.3%) in 2018 alone and by 9.2 million or by about 18.0% over the next five years, driving both strong short- and long-term demand for medical services. Overall elevated spending trends escalated by sheer numbers of older people requiring greater care than younger population cohorts are expected to continue LINCOLN ADVISORS 1 LINCOLN HARRIS CSG

2 into the foreseeable future, regardless of per capita spending costs. According to recent data from the U.S Centers for Medicare and Medicare Services, the total healthcare spend from 2017 to 2026 is projected to grow annually by 5.6%, reaching nearly 19.7% of total GDP. 2 U.S. Healthcare Expenditures Sources: Centers for Medicare & Medicaid Services, Office of the Actuary; U.S. Department of Commerce, Bureau of Economic Analysis; and U.S. Bureau of the Census. UNDERLYING HEALTHCARE TRENDS While the number of high-need patients increase, we expect necessary expense-cutting strategies, in part mandated by the Affordable Care Act, are likely to drive more care providers from high-cost hospital complexes into more affordable outpatient facilities, including physician offices, emergency care clinics, diagnostic laboratories and surgical centers. New technologies also are helping move patients away from hospital treatment to lower-budget outpatient alternatives, including urgent care centers and other medical offices. 3 This trend implies fewer overnight beds in traditional hospitals, and continued growth in operating rooms and ICU beds in health systemsponsored neighborhood clinics. With this shift to outpatient care underway, we believe the accompanying healthcare industry focus on value, consumerism, consolidation and transformative innovation will likely intensify demand for capital investment in healthcare facilities and renovation or new construction of medical office buildings, according to the Healthcare Financial Management Association. We believe these favorable trends for the medical office market will continue despite uncertainty about the Affordable Care Act and national health care policy. Increasingly, facilities locate near existing healthcare campuses or in retail settings convenient to residential communities. Larger health systems and physician groups seek to diversify locations to offer greater convenience and gain greater market shares. Medical office facilities may include urgent care, freestanding emergency centers, doctor offices, imaging centers, ambulatory surgery centers, and outpatient treatment facilities. Tenants seek the lowestcost or most cost-effective environment possible, preferring modern facilities capable of integrating complex, evolving technologies and machinery for radiology and surgery procedures. We foresee that buildings near large patient populations offering specialized services like dialysis are also poised for strong user and investor demand. Some larger healthcare systems provide multiple services in one location, ranging from primary care visits, imaging, cardiology, gastroenterology and orthopedics to entertainment, exercise, and casual dining engaging patients while waiting to see doctors. On a smaller scale, more doctors share clinic space with compatible specialists in multiple locations so they can share costs and refer business to each other. 4 As the business of healthcare changes, many physicians have become more-sophisticated business participants in joint medical ventures, involving real estate, taking equity ownership stakes in medical office buildings and development projects. Developers encourage these arrangements because physician-tenants are more likely to sign on early for projects and agree to longer lease terms. Hospitals planning new medical office projects on their campuses also increasingly partner with third-party developers and sponsors rather than constructing, owning, and managing the facilities themselves. MARKET DYNAMICS Occupancy trends are higher than traditional office at above 90% and the sub sector registered a lower peak vacancy rate during the last recession. The national medical office vacancy fell for the sixth consecutive year in 2017 to an all-time low of 7.2%. 5 Major markets like New York and San Francisco register sub-5% vacancy rates, but a range of other disparate markets show tight supply/demand LINCOLN ADVISORS 2 LINCOLN HARRIS CSG

3 U.S. Medical Office and Supply Source: CoStar fundamentals too Nashville (2.8%), Louisville (4.9%) and Kansas City (5.5%). Net absorption has outpaced new supply in 24 of the past 29 quarters and has strongly outpaced supply since Deliveries of new medical space have trailed pre-recession levels, according to CBRE, and medical space currently under construction has decreased slightly from a second quarter 2016 peak. This construction trend is expected to continue through 2018, with tenant demand supporting the amount of new supply. Overall medical office rents have been relatively stable in the $22 to $23 per square foot range nationally with significantly higher rents captured in high demand/supply constrained/high cost markets like New York and San Francisco. Our experience has shown that the most sustainable tenant practices are those that are supported by solid insurance contracts, and those businesses that underwrite favorably to Medicare and Medicaid reimbursements. Expensive buildouts and the requirement for proximity to patients and hospitals encourage medical office tenants to stay in place for extended timeframes, reducing turnover and helping ensure predictable net operating incomes. INVESTMENT METRICS Recent sale pricing for medical office has surpassed traditional suburban office on an average per square foot basis, driven by its high appeal factors, demographic underpinnings, asset class stability, investment credit tenancy, and longterm lease structures. 6 Approximately $2.5 billion of MOB sales transacted during the first quarter of 2018, making it the second-largest first quarter ever in dollar volume. 7 U.S. Average Cap Rates Source: Real Capital Analytics LINCOLN ADVISORS 3 LINCOLN HARRIS CSG

4 Investor demand has increased as institutions look beyond over-bought asset sectors for yield and better risk adjusted returns. Cap rates on some deals test record lows under 5% and the four-quarter trailing investment volume totaled more than $12 billion in both Q2 and Q3 2017, the highest since Real Capital Analytics began tracking medical office properties in Thus far in 2018, the rolling 12-month total sales volume is reported to be approximately $11.4 billion, according to Real Capital Analytics. 9 As long-time owners seek to cash out into ramped up buyer demand, transaction opportunities include large portfolio trades as well as individual asset dispositions, ranging as high as $400 million for a major complex. APPROPRIATE RISK-RETURN STRATEGIES Investors seeking to build meaningful medical office portfolios and take advantage of the evident future growth prospects can find opportunities across the investment spectrum in core, core plus and value add strategies. Lincoln Advisors focuses on direct investment in separate accounts and programmatic joint ventures to navigate market changes more effectively and control asset management decisions. Lincoln Advisors leverages its capital expertise with the sourcing and operating advantages of its healthcare real estate affiliate, Lincoln Harris CSG. Since entering the healthcare real estate space in 1997, Lincoln Harris CSG Healthcare Group has developed and executed real estate strategies for healthcare providers, hospitals, healthcare systems and medical office investors. Lincoln Advisors provides the link to a plan sponsor-operator relationship that provides detailed insight into the medical office arena extending to property management, leasing, project management, accounting, compliance, fair market valuations and real estate acquisitions/dispositions. Core: Long-term investment in well-leased medical office offers relatively low risk stabilized cash flow from high-credit tenants in customarily long-term leases. Lincoln seeks to build portfolios of outpatient facilities with strong credit medical system sponsorship, state-ofthe-art real estate, strategic tenant mix and geographic diversity. Preference is given to assets with a strategically important role in the healthcare model, that contribute to the full suite of services offered by a healthcare organization to satisfy the spectrum of a given neighborhood s medical needs. helps ensure properties effectively serve tenants and their changing technological and market requirements. Non-Core: Lincoln favors two portfolio acquisition approaches in executing non-core strategies, which focus on lease-up and repositioning opportunities. These opportunities can span the risk continuum from core-plus to value-add: Acquire a significant existing medical office portfolio and aggregate additional complementary assets, divesting weaker assets and adding complementary properties, or Aggregate a large portfolio through individual transactions, according to desired risk-return requirements. In both cases, locations are sought with solid demographic growth trends and assets with good system sponsorship and above average payor mix. Divestment focuses on assets which do not provide risk mitigation exposure from either geographic or medical system sponsorship diversification. Once a portfolio with sufficient diversification and credit quality is assembled, a sale strategy would target institutional core buyers. Conversely, a plan sponsor may elect to hold the assembled, stabilized portfolio long-term for cash flow. A core portfolio can be assembled through the acquisition of existing leased assets, developed in a build-to-core program, or a combination of the two strategies. Once assembled, active asset management LINCOLN ADVISORS 4 LINCOLN HARRIS CSG

5 LINCOLN ADVISORS Lincoln Advisors, a division of Lincoln Property Company, is a boutique manager of separate accounts invested in U.S. commercial real estate for a select group of institutional clients. Lincoln Advisors specializes in value-add and core strategies, tailored to meet the objectives of clients, who benefit from access to investments originated by Lincoln Property Company regional operating executives. For more than 50 years, Lincoln Property Company has provided development and property management services for institutional income-producing assets. By limiting its engagement to a small number of clients and employing an owneroperator s mindset, Lincoln Advisors delivers personalized service managed directly by hands-on senior executives, who oversee all aspects of acquisition, development, redevelopment, asset management, property management, and leasing strategies. Lincoln Advisors prides itself on a high level of attention to detail, service, and performance dedicated to creating value and maintaining long-term relationships. LINCOLN HARRIS CSG The healthcare division of Lincoln Property Company, Lincoln Harris CSG is a national healthcare real estate firm. The company is solely focused on delivering real estate solutions for hospital systems, healthcare providers, and medical office investors, managing 34 million square feet of medical office space in 19 states and closing in excess of 2,500 healthcare transactions annually. Lincoln Harris provides property management, transaction services, project management, and valuation/compliance services to support clients investment and business goals, seeking optimal real estate performance outcomes. 1 Center for Medicare & Medicaid Services. NHE Projections Retrieved June 26, 2018, from 2 US Census Bureau, National Population Projections GlobeSt.com. Costs and Tech boost Demand for MOB. Retrieved January 23, 2018, from 4 Globest.com. Institutional and Foreign Investors Enter Health Arena. Retrieved January 23, 2018, from 5 Medical Office and Health Care Report CBRE. Retrieved January 23, Medical Office Building Quarterly Update-2Q17. Medical Office Building Appeal Growing and Cap Rates Compressing as Flight to Quality Takes Place. Hammond Hanlon Camp LLC. Retrieved January 23, First Quarter Medical Office Building (MOB) Report. Hammond Hanlon Camp, LLC posted June 5, Retrieved October 8, US Medical Office Volume and Cap Rates. Real Capital Analytics. Q Retrieved February 21, Trends and Trades Sales. Real Capital Analytics. Created on October 8, LINCOLN ADVISORS 5 LINCOLN HARRIS CSG