The Medical Office in the Time of the COVID-19 Recession
Speaking very generally, there have been two phases in the evolution of the modern, on-campus medical office building (MOB). The first phase, which ended after the 2001 recession, was the on-balance-sheet phase. The second and current phase is the off-balance-sheet phase.
In the first phase, health systems tended to own the MOB properties surrounding their hospitals. The health systems regarded MOBs as a way to attract and reward the specialist doctors who referred patients to the hospitals. The rents were often below market, and the MOBs tended to be managed inefficiently. The real estate lending community regarded MOBs as an “Alternative Asset Class.”
In the second phase, health systems engaged in sale-leasebacks and off-balance-sheet development of MOB’s, while usually retaining a ground lease. The second phase began for multiple reasons. As always in the healthcare sector, the number one reason was the explosion of costs. Healthcare systems simply needed to manage their assets and balance sheets more effectively. A second reason was the government prohibition of lease subsidies for doctors, commonly known as the Stark Laws. And finally, REITS and other institutional investors woke up to a compelling investment thesis, which included consideration of these factors:
- With healthcare costs spiraling out of control, more and more healthcare was expected to migrate from hospitals to outpatient facilities.
- The aging of the population. Baby-boomers started turning 65 in 2011, and demand for outpatient care was expected to stay steady or expand.
- Proximity to a hospital is a built-in competitive advantage.
- Doctor tenants would continue to charge their patients on a fee-for-service basis.
- Medical leases have longer terms and higher rents.
- Tenant retention is higher in MOBs.
- Last but not least, MOB’s are recession-resistant because patients always prioritize medical care.
Phase Two ushered in the golden age of MOBs. Instead of being considered an “Alternative Asset Class” that was difficult to finance, MOBs gradually became an “Institutional Asset Class” favored by REITs, PE firms, and life insurance companies. The Great Recession of 2008 confirmed that MOBs are recession-resistant. They performed significantly better than conventional office properties.
The COVID-19 recession has tarnished the prestige of MOBs. Patients have postponed nearly all elective procedures. Many medical practices have more or less shut down for several months and obtained PPP loans. Early evidence suggests that many MOB tenants have requested rent relief. In short, COVID-19 has reminded us of two important facts about MOBs:
- First, not all healthcare can be performed in an outpatient setting. COVID-19 patients spend multiple days and nights on a ventilator, which can only happen in a hospital.
- Second, MOBs are a hybrid property type involving both office and retail. They are therefore subject to some of the same factors that affect retail real estate.
Will the COVID-19 recession permanently reduce MOB values? It seems unlikely. Although MOBs have been proven vulnerable to a medical crisis, the other elements of the MOB investment thesis remain as valid as ever. Meanwhile, the endless push for cost control keeps ramping up regulatory compliance costs. Small medical practices struggle to survive. The result is larger and financially stronger tenants, which will enhance MOB values. The COVID-19 recession will probably accelerate this trend.