The Medical Real Estate Conference, hosted by BOMA International this past May, featured a range of speakers in the healthcare real estate field to discuss the growing trends and predictions for the future. Travis Ives, moderator, and Tyler Morss, panelist, of the session, “Converting Existing Structures into Medical Facilities: A Strategic Overview,” described their takeaways from the event and elaborated on challenges and opportunities in conversion projects.
Read the insights below to learn more from Travis Ives, Executive Director, and Tyler Morss, Director, both with Cushman & Wakefield’s Healthcare Capital Markets Team:
Dynamics Driving the Medical Conversion Trend
“Medical office occupancies have been steadily increasing across nearly every US market with the national average now hovering around 93%,” Ives says. “Additionally, new construction starts are down and the majority of new deliveries are pre-leased or owner-occupied. The limited inventory of new space that is available for lease requires rents 30-40% higher than asking rents on existing medical space. Meanwhile, traditional office buildings are struggling with decreasing occupancies resulting in distressed owners that are desperate for tenants, and in some instances, are giving up and handing the keys back to the lender. These conditions set the stage for the office-to-medical conversion trend we’re now seeing across the country.”
Qualifying Medical Conversion Opportunities
Despite the plethora of distressed office buildings now being marketed for conversion to medical, not all conventional office buildings are strong candidates for this strategy. "When evaluating a conversion opportunity, certain physical elements of the structure need to be carefully considered including parking, elevators, mechanical, electrical and plumbing. Sometimes the cost to convert a building to meet the demands of medical tenancy will outweigh the benefit of building a new ground-up facility.”
Healthcare Real Estate Financing
“Despite the strong relative performance of medical office buildings, debt markets have remained tight due mainly to external forces impacting lenders,” Morss says. “Many local and regional banks that used to be quite active in healthcare real estate have pulled back over the last 18-24 months.” As forecasted in Cushman & Wakefield’s Vital Signs: May 2023 Medical Office Captial Markets Update, capital markets across all CRE asset types have been impacted by rising interest rates, tighter lending standards and overall caution over the slowing of key economic indices. C&W will soon be releasing an update to that report.
“The need to increase their deposit-to-loan ratio is top of mind for many bank lenders,” Morss says. “The limited capacity banks have available for lending is prioritized for relationship borrowers that have a long history with the bank. This situation has left the door open to new sources of capital that have traditionally not been as active in healthcare real estate. For more capital-intensive investments, like an office-to-medical conversion, alternative sources of financing, such as debt funds, are willing to provide higher leverage and more flexible terms that allow borrowers to execute on a conversation strategy.”
Tenant Improvement Costs
The single largest expense in converting office to medical is the tenant improvements costs. “Depending on the market, the total cost of a generic medical office build-out from shell condition has risen sharply in recent years ranging from $150 to $300+ per square foot,” Ives says. “A landlord’s willingness and ability to fund a large tenant improvement allowance will determine its success in procuring medical tenants. In exchange for the investment, landlords will be rewarded with higher rents and longer lease terms, generating a stronger value for the building when it’s later sold or refinanced.”
The JLL Medical Outpatient Building Perspective reaffirms the impact of rising construction costs for medical tenant improvements. The report suggests that occupiers “limit out-of-pocket expenses through seeking second-generation space or trading free rent for additional tenant improvement dollars.” Despite the challenges this presents, according to the report, outpatient volumes will continue to grow, and a comprehensive, data-driven location strategy can help find the right sites to target for growing specialties plus optimize performance in existing sites. “Exploring opportunities to monetize real estate or partner with developers can allow health systems to free up capital to focus on patient care,” the report says.
Final Takeaways
During the “Converting Existing Structure into Medical Facilities” session, moderator, Ives, asked attendees to complete a poll to determine the audience’s experience with medical conversion projects. The results found that 80% of attendees had recently been involved in a medical conversion project; 91% consider it to be a success; and 100% expected to be involved in a medical conversion project moving forward. “Although we expected much of the audience to be interested in the topic, we did not anticipate the response rates to be so high. This reaffirms our expectations that we will continue to see more conversions of office-to-medical as both investors and occupiers seek ways to deliver care in the most cost-effective manner possible.”