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Posted: Monday, July 21, 2008

A New Lease On Life

As senior vice president in charge of development for Pacific Medical Buildings, Rohan has been furiously shuttling between two major projects under construction in the L.A. area: a 190,000-square-foot, $80 million medical office tower next to Huntington Hospital in Pasadena set to open next year and a 97,000-square-foot, $38 million medical office building next to Providence St. Joseph Medical Center in Burbank that will open next month.

Those are just two of the largest medical office projects Rohan is overseeing. “Right now, we have a record amount of volume under construction,” he said.

As if that weren’t enough, Rohan is pushing to break ground next year on a 107,000-square-foot medical office project in Torrance that’s in the entitlement phase. The San Diego development company is also in the early stages on two medical office properties in Santa Clarita.

Pacific Medical Buildings is hardly alone.

All over L.A. County, new medical office buildings are either under construction or in the planning stages, and older properties are hastily being converted into top-flight medical office space. Meanwhile, rents for quality medical office space are soaring in many parts of the county, drawing in new investors.

In a word, medical office space is hot, especially in lucrative markets like L.A.’s Westside, previously untapped markets like Santa Clarita and near major hospitals. The boom couldn’t come at a more opportune time: General commercial office construction has slowed dramatically as the economy has slipped and financing has mostly dried up. 

“Medical office is definitely one of the few bright spots now in an overall down market,” said Greg Trotter, senior investment adviser with Coldwell Banker Commercial in the San Fernando Valley.

Countywide, the medical office vacancy rate was 5.8 percent during the second quarter, according to data from CB Richard Ellis Group Inc., a New York-based commercial real estate services company. That’s up from 4.7 percent in the second quarter of 2007, but is still only about half the commercial office vacancy rate of 10.8 percent. The primary reason for the increase is the number of new buildings coming on line.

Lease rates, meanwhile, increased to a countywide average of $2.62 per square foot in the second quarter from $2.48 a year earlier. However, many brokers reported that lease rates in the most desirable areas for medical offices have increased to around $5 per square foot.


Boom trends

Several factors have converged to drive this boom and are likely to sustain medical office activity through the current economic downturn: 

• An aging population that requires ever more medical services;

• Advances in technology that allow increasing numbers of medical procedures to be done in offices outside of a hospital setting;

• A state law requiring hospitals to retrofit their buildings to meet seismic standards, which in turn is prompting hospitals to move services that don’t require overnight stays into office settings;

• Tight medical office markets in many areas as little new construction came on line for several years;

• Rapid population growth in outlying areas that has outstripped the supply of medical offices; and

• Increasing interest from investors looking to take advantage of high lease rates and a generally stable physician tenant base.

Many of these trends have been in the works for years. But it’s only in the last two or three years that rents have risen far enough to justify building new medical office space. That’s because stiffer building code requirements – especially for parking – and physician demands for expensive amenities have combined to make medical office buildings roughly twice as expensive to construct as conventional office buildings.

“In today’s world of construction, a typical office building runs about $40 per square foot, while generic medical office space runs between $80 and $90 per square foot,” said Steve Salas, vice president with Madison Partners in Brentwood, which manages more than 1 million square feet of medical office space in Southern California.

Higher plumbing costs, the need for thicker walls and especially requirements for more parking spaces per thousand square feet all contribute to these higher construction costs (see sidebar, page 19).

This helps explain why in the early years of this decade, the construction of medical office buildings in the L.A. area failed to keep pace with rising demand. Office shortages became most acute in places like Beverly Hills, L.A.’s Westside and the South Bay, where affluent populations have sought increasing levels of medical procedures – from cosmetic dentistry to weight control surgeries – but where space for new buildings is at a premium.

As a result, medical office rents have soared to nearly $5 per square foot in these locations, about double the rents for conventional office space.

That’s one reason why earlier this year that New York-based LeFrak Organization Inc. paid a record $865 per square foot for a 64,000-square-foot medical office building on Spalding Drive in Beverly Hills. The previous owners had purchased the building in December 2006 for $609 per square foot.

With prices and rents like these, it’s no wonder that investors are now jumping into the fray, from large real estate investment trusts like Newport Beach-based Nationwide Health Properties and Long Beach-based HCP Inc. to individuals and small groups of physicians. 
“Everyone wants to own medical office space all of a sudden,” said Dr. Michael Hayavi, chief executive of Beverly Hills Physicians, a private medical group specializing in plastic surgery.

Beverly Hills Physicians has grown from three centers in 2005 to seven today, including one that just opened in Thousand Oaks.

Hayavi himself owns a medical building in Beverly Hills. He said that when he acquired the property in September, the lease rate was roughly $2.50 per square foot. “We have re-rented that space at $6 per square foot.”

Hayavi is one of a new group of medical building investors that have become increasingly active in recent months – mostly small groups, either physicians or other small investors.

“The market for medical building investors has always been fairly strong, but now we are seeing a flight to quality as people roll out of investments in multifamily units or retail strip centers and into medical buildings,” said Coldwell Banker Commercial investment adviser Trotter.

It helps that physician groups tend to be relatively stable tenants. “Smart landlords love medical office clients, since they typically sign five- to 10-year leases and continue to renew unless they need to expand, sell off to a partner or retire,” said Salas of Madison Partners.

Meanwhile, in the South Bay, medical office condos are the latest trend, with physician groups choosing to own space instead of leasing it at what are now record-high rates, according to Paul Carrise, another Coldwell Banker Commercial agent.


Outpatient Trends

Investors and developers aren’t the only ones cashing in on the medical office boom in the L.A. area. Construction contractors, architectural firms, and wiring and plumbing contractors are among those benefiting. The additional work in the medical services area is helping to offset slowdowns in other lines of work.

“We’re getting cold calls for build-to-suits for medical office space,” said Alex Guerrero, executive vice president with Sun Valley-based Tower General Contractors.

By far the biggest factor behind the surging demand for medical office space has been the trend toward outpatient services.

Over the past 25 years, many procedures that were strictly done in a hospital setting and often required overnight stays – such as colonoscopies – are increasingly done in office visits that last just a few hours. Some of this has been driven by advances in technology that have reduced the size of diagnostic machines. 

But much of this is due to cost-cutting procedures by hospitals and health insurers, since inpatient hospital stays can cost thousands of dollars per day. “(Insurer) reimbursements are driving this. Inpatient stays are very expensive, so outpatient stays are favored for reimbursement,” said Bernadette Merlino, vice president of service line and ambulatory development at Huntington Memorial Hospital in Pasadena.

Consumers also have shown a preference to have these procedures done in an outpatient setting that is closer to home usually more customer-friendly than a hospital setting. Attending physicians, though they still want to be near hospitals, have also pushed to be in more convenient office towers.

In addition, procedures have sprung up that don’t need to be performed in hospitals, such as lapband gastric surgery or laser eye surgery.

All of this has coincided with major hospital overhauls prompted by California’s seismic retrofit law. Passed after several L.A.-area hospitals experienced greater-than-expected damage in the 1994 Northridge Earthquake, this law imposes deadlines on hospitals to retrofit their facilities to meet the latest in quake safety codes. As a result, local hospitals have already spent billions of dollars and will have to spend billions more to be in complete compliance. (For more, see story, page 22.)

But because hospital construction costs are so astronomical, hospital administrators have used the opportunity to move as much out of the acute-care hospital setting as possible, accelerating a trend that was already under way.

Take Huntington Memorial Hospital in Pasadena. As its $200 million seismic retrofit program was winding down, the board decided to consolidate most of the physician office space on the hospital campus into a 190,000-square-foot office tower, along with outpatient imaging services and a cancer treatment center. Huntington Memorial signed a long-term lease with Pacific Medical Builders to develop the medical office tower.

“The whole concept of the building is a one-stop shop for patients outside of the immediate hospital setting,” said Huntington’s Merlino.

Construction began late last year and is expected to wrap up by mid-2009.

A similar need for more outpatient and physician office space is evident at the Santa Monica UCLA Medical Center and Orthopedic Hospital, which was damaged during the Northridge quake and is now in the midst of a complete replacement project. This need drew the interest of L.A.-based developer Arnon Development Co., which is planning to build a $32 million, 45,000-square-foot medical office building adjacent to the hospital.

Arnon Chief Executive Randy Miller said both major Santa Monica hospitals – the UCLA Medical Center and St. John’s Hospital – are now in the midst of full replacements and that as a result of the trend toward outpatient services, total bed counts will be going down.

“These facilities have the need for additional medical office and outpatient services, which is why we’re pushing ahead with the development of the medical office building,” Miller said.

Arnon just wrapped up construction of a smaller office building: a $12 million, 17,000-square-foot structure in Westwood that has been leased to sole tenant DaVita Inc., an El Segundo-based dialysis services provider.

However, Miller said he is a little nervous about the ability of medical office developers to get funding in coming months. “With the capital markets the way they are right now, things are already slowing down on the general commercial side. I’m concerned that this could spread to medical office construction.”

Other medical office market watchers and brokers said they are already seeing a slight slowing in the hot medical office construction market.

“It’s gone from high demand everywhere to high demand in some locations and slowing demand elsewhere,” said Jim Jandro, senior vice president with Grubb & Ellis Co.

Still, demand is likely to continue, especially in places like Santa Clarita, where the population has burgeoned and is beginning to age. In response to these trends. Henry Mayo Memorial Hospital is expanding and building three new medical office buildings totaling 200,000 square feet.

“You’ve got two powerful forces acting there: population growth, with one person being added each hour, and a population that continues to age. That’s always good if you’re a medical service provider,” said Craig Peters, executive vice president with CB Richard Ellis Inc.

Article By: Howard Fine of Los Angeles Business Journal


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