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High Interest Rates, Tight Supply Create Challenges In Healthcare Real Estate

Devenney Group Architects' Scott Mackey, One Medical's James Goldberg, Arup's Raj Daswani, Taylor Design's Eric Peabody and Pankow's Baris Lostuvali

Perennially recession-resistant medical office buildings are once again poised to maintain their profitability, at least in the short term, as other asset classes suffer, but healthcare real estate is not without challenges in the wake of the greatest health crisis in a century.

Providers and patients have higher expectations of what their medical facilities provide, and money is more expensive and difficult to come by than it has been in decades, making it tough for smaller, specialized providers to expand in the way their patients want.

And the supply of properties is tight, leading more clients to look into the feasibility of converting smaller conventional offices into medical office space, Taylor Design principal and Project Director Eric Peabody said at Bisnow's Northern California Healthcare event, held Tuesday at the San Francisco Marriott in Union Square.

“In the first session up here, they were talking about the tight supply of institutional office space, and we are finding we’re doing quite a lot of work for our clients, test-fitting office buildings and seeing what it takes to convert them from office use to medical office,” he said.

Peabody noted that particularly in the San Jose and South Bay area, one of the challenges increasingly faced when attempting these conversions is the extent of the upgrades required.

“You’re ending up having to upgrade the buildings from a Type 3 construction to a Type 2 construction, which oftentimes means pulling the whole skin so you can fireproof the structural system," he said.

But at the same time demand for conversions spiked in California, investment opportunities started drying up amid the scramble for easily redeveloped properties, leading capital to explore other markets, such as Florida or Texas.

Within those markets, rural areas with less competition are becoming hot spots for those looking to score deals, according to Unity Medical Properties CEO David Lynn.

“I see other opportunities in other sectors within regions around the country, outside California. That’s where some of our investors are investing with us,” he said.

Lynn said while there are ample regional opportunities outside of the Golden State, nationwide the increased financial stress caused by a recession will also lead to more property changing hands.

“One of the things I touched on previously is that there will be debt coming due and there will be opportunities for you to create transactions from that stress,” Lynn said.

Lynn also noted that with increased hesitation from institutional capital and rising interest rates, Unity has looked increasingly to regional banks in order to get a better bottom line on the financing end of things.

“We use a lot of regional banks and local banks for our acquisitions. And it’s gone very well for us, because what that allows us to do is keep our costs of capital down where they might be financing in the sixes, we are financing in the low fives.”

Additionally, the growth of market stress has created opportunities for smaller, specialized medical facilities, such as fertility clinics or behavioral health centers, with an uptick in overall smaller leases trending, according to Bayside Realty Partners CEO Trask Leonard.

“I would say this applies mostly to non-healthcare system tenants. But the last six to 12 months, we’ve seen a dramatic increase in the small tenant leasing activity in many markets,” he said.

“I think a lot of them view this as a pretty good opportunity to get back into the marketplace and expand, things like fertility clinics, behavioral health, plastic surgeons, many discretionary practices."