Health care real estate experts discuss the need for more outpatient facilities, the pros and cons of new construction versus adaptive use, the issues related to obtaining financing, the impact of new technologies, and other trends.

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What implications does the Affordable Care Act have for real estate development and investment in the health care sector?

Jeffrey Cooper: Because more people will have health insurance coverage under the Affordable Care Act, fewer people will end up in the emergency room, where people tend to go if they don’t have health insurance. Instead, they will receive care at some form of outpatient setting covered by their insurance. Also, because health care providers are facing reduced reimbursements from Medicare and private insurance sources, hospitals and physicians can no longer afford to provide as much care in inpatient settings. As a result, the development of ambulatory facilities and medical office buildings is increasing to allow these providers to deliver more cost-effective care. These facilities are often being built away from the main campus, either in smaller campus settings or in clinics that are closer to the homes of both physicians and their patients.

Chris Bodnar: Because of declining reimbursements, health care systems are trying to stabilize margins by realizing economies of scale any way they can. That means more merger and acquisition activity to allow them to better negotiate with insurance companies by increasing the number of lives they represent. It also means leveraging third-party experts who already have economies of scale in areas that are not necessarily health systems’ core competency, including real estate. Real estate services providers have the advantage of managing billions of dollars of vendor contracts, so they can pass on savings to health systems. Health systems are also looking to increase revenue by entering new markets. A good example is a facility that CBRE just sold in Cherry Hill, New Jersey, an affluent suburb of Philadelphia, which was leased to a health system based in Camden, New Jersey, a struggling community. The system brought together different cardiology practices into one location at a prime intersection to take advantage of the strong demographics of the Cherry Hill community.

Jeffrey Land: Some of the changes that we are talking about in reaction to the Affordable Care Act really started several years ago as we began seeing increases in mergers and consolidations across the country, for large systems as well as individual hospitals. Moody’s has now issued a report saying not only that merger activity is expected to continue, but also that “virtual mergers” are on the rise. In this type of consolidation, the hospitals come together in nearly all ways except in the area of debt, where it’s too expensive or too difficult to consolidate. All these behaviors will most likely continue, resulting in fewer, larger systems that can achieve the operational efficiency that will be necessary if reimbursements continue to drop.

What kinds of challenges are health care providers facing in obtaining financing and capital for real estate development projects?

Eric Fischer: The methods that health care systems are using to approach financing real estate vary depending on the markets they are in. In cities like Washington, D.C.; New York; Boston; San Francisco; and Los Angeles, which have expensive real estate, high cost barriers, and regulatory entitlement issues, health care providers appear to be moving more toward a lease-type model for outpatient/off-campus clinical services. They are leasing space in an existing building and adapting that space to consolidate clinical services and physicians. When they do build facilities from the ground up, they will most likely pair up with a highly experienced development partner to mitigate the development risk. They have to be in line with a developer that knows its market very well and knows how to deal with the high barriers to entry and can offer efficient design, speed to market, and construction solutions. If health systems extend into new markets, they will most likely choose more flexible leased-space options to test whether their assumptions were correct.

Cooper: Financing doesn’t seem to be a problem for health care systems, for two reasons. First, the higher-credit-rated hospitals seem to be building with their own funds for the most part, and they have been able to borrow at historically low rates, notwithstanding the uptick in interest rates from [last] spring to summer, which [as of late 2013] seems to have leveled off temporarily. In addition, many of the larger health care developers have aligned themselves with third-party capital sources, including large publicly traded REITs [real estate investment trusts], nontraded or thinly traded REITs, family offices, pension funds, and private equity sources—all of which are actively competing to provide capital to the hospitals for the development, redevelopment, or monetization of their real estate.

Bodnar: Despite all the challenges facing health systems because of the Affordable Care Act, investors seem to have an insatiable demand for the health care real estate sector. Investors are still concerned about the possibility of slipping back into a recession at some point, and people are going to get sick in a good economy or a bad economy. The number of people who are going to need care is only going to increase, given the demographic trends. Institutional investors such as pension funds, life insurance companies, and foreign investors are interested in the health care sector. These institutions have traditionally shied away from health care, because they weren’t familiar with it and because a large medical building is only about 70,000 square feet [6,500 sq m], whereas these institutions typically invest in much larger properties. Some institutions are partnering with operators that bring health care expertise to the table, understand this asset class, have the right relationships, and are able to aggregate a number of facilities for the institutions to invest in, making the deal larger.

rndtbl_1_351When health systems are looking to add ambulatory facilities outside their main campuses, what are the advantages of new construction compared with redevelopment?

Land: The adaptive use strategy—converting failed retail centers and office buildings to medical uses—came to prominence mainly because of the economic downturn over the last few years. But there is a useful alignment today between health care’s increasing consumer orientation and the possibilities of retail-type spaces as health care systems try to make services more accessible and convenient for the people they serve. In part, consumer orientation is behind the proliferation of “minute clinics” in grocery stores and drugstores, and that will continue, because it’s cheaper and more convenient to provide limited services in those settings. I’m not sure it matters whether a comprehensive clinic is located inside a retail mall or across the street from it. Health care is not an impulse buy; it’s a destination.

Cooper: Existing inpatient or outmoded facilities can be converted to ambulatory uses, but that can be a more expensive and less-than-adequate proposition than building a new facility. The consequence is that we should see more new construction. Some systems, like Kaiser Permanente, have been very effective in converting existing facilities for ambulatory use—usually office buildings that happen to be in important infill locations. But they are more the exception than the rule.

Bodnar: The site that I mentioned in Cherry Hill had previously been a grocery store. They took the building down to the studs and completely renovated it for the new use. It all comes down to location. Health care systems are looking for areas with affluent demographics, locations with high foot traffic, and prominent sites that help a system establish a strong brand. We are seeing much more openness by health systems to use third-party equity for off-campus types of facilities, whereas traditionally, a lot of these health care systems have used their own equity to fund on-campus development.

Fischer: During the economic downturn, when there were considerably higher vacancies in certain markets, many health care providers took advantage of the oversupplied speculative suburban office product and effectively secured low lease rates or attractive acquisitions. The very low lease rates or acquisition prices allowed the building’s operational inefficiencies to financially function. Now that the market is beginning to tighten, particularly in Washington, D.C., some owners of high-quality, Class A office or retail product are becoming more reluctant to allow a health care provider to lease or acquire space in a building not specifically being marketed or designed for medical use. Facilities for ambulatory surgery and heavy diagnostic services typically require more complex mechanical, electrical, and plumbing systems and can accordingly cost upward of $200 to $400 per [square] foot in additional tenant improvement finish costs. These excessive improvement costs are challenging to recapture over a ten- to 15-year lease term in addition to a more costly or restricted base lease rate. Accordingly, a well-designed, ground-up integrative medical plaza with its high slab-to-slab clear height and a core configuration that allows for both a deep and a shallow bay user positions the newly constructed building for multiple longer-term uses and secondary lives.

What other trends are shaping the health care sector?

Bodnar: Cash is king right now for health care systems. Rating agencies understand that given the prospect of declining reimbursements, good liquidity is crucial for a health care system. A lot of health systems have their equity locked up in real estate, and their cash on hand is low. So they have to take a strategic look at what assets in their portfolio are mission-critical properties and what other assets could be converted to cash that they could put on the balance sheet to enhance their standing with the rating agencies.

Cooper: In some locations, especially in Texas, there are a lot of physician-owned facilities—particularly surgery centers and ambulatory facilities—that are private-pay facilities and do not take Medicare. Patients have to either pay for care themselves or with private insurance. These facilities tend to be attractive to third-party payers, because they can offer their services for less and they don’t have to support an inpatient facility, provide charity patient care, or supply low-reimbursed care to Medicare or Medicaid patients.

Fischer: Health care providers are turning to research tools that have traditionally been used in the retail sector—psychographic and demographic mapping that allows them to understand what influences a potential client to use their service. Many health systems are embracing a retail mind-set, moving closer to population bases and precisely targeting those populations. Historically, health systems built centralized facilities, and we all traveled to them. We will continue to travel to them, but only if we require more intense or acute-care services. Many of these consolidated facilities have a true retail setting and retail feel, and they have services that have been carefully analyzed to match a particular subset of the population.

Land: One of the goals of the Affordable Care Act, by creating accountable care organizations, is to make sure that hospitals reduce readmissions. When a patient leaves a hospital and remains healthy, that frees up a bed. Improved readmission rates will take some of the pressure off the need to expand. Also, we need to continually reinvent ambulatory care and take advantage of new technologies as they become viable. Some simple and inexpensive medical devices are being tested for iPhones, for example, that should improve remote monitoring and lower costs. The quality of what can be achieved with technology continues to improve. So now the questions we must ask are: What will the role of remote monitoring be in the future? How much can we bring care to underserved populations by using mobile settings, and what impact will these have on the built environment? UL

Ron Nyren is a freelance architecture and urban planning writer based in the San Francisco Bay area.