🔒Despite office sector’s woes, demand for medical space remains robust

Boston-based Sendero Capital and alternative investment firm Angelo Gordon partnered earlier this year on a $300 million effort to acquire outpatient medical office buildings in a corridor stretching from just north of Washington, D.C., to New England.

The partners’ first acquisition in June brought them to Connecticut, where they paid $8.9 million for a 53,120-square-foot medical office building in Hamden. Anchored by Hartford HealthCare, the building was 88% occupied at the time of the sale, including by physicians in a range of specialties.

The partners’ fourth investment, in October, also took place in Connecticut — an $8.15 million purchase of a Torrington property hosting two fully leased medical office buildings totaling 37,721 square feet.

Sendero Capital Principal Ross Negele said his group is considering additional Connecticut acquisitions.

“We look at outpatient medical and its shift to the suburban environment as a positive for patients and providers and the future of care,” Negele said.

Experts agree demand for medical office space remains strong in Connecticut, although high interest rates coupled with other healthcare industry challenges are prompting some to hold back on new construction.

Across real estate asset classes, builders are finding increasingly reluctant lenders and stubbornly high construction costs.

Connecticut’s demanding regulatory approval process is another roadblock to new construction, making existing healthcare facilities increasingly attractive to investors, experts say.

Higher rents

According to Maryland-based healthcare real estate data provider Revista, the amount of medical office space in Hartford, Tolland and Middlesex counties has increased by 20% over the past decade, to 6.8 million square feet as of the first quarter of this year.

Occupancy has hovered around 94% for a decade.

Revista Principal Hilda Martin said construction of medical office space has slowed nationally, even as demand remains strong. The amount of new U.S. medical office space being added is hovering around 1% annually, but space is being occupied at a faster rate, Martin said.

“I think it’s very similar to other sectors; you have players sitting on the sidelines waiting for other things to shake out,” Martin said. “There is a disconnect between lender interest and investor interest.”

The amount of medical office space added annually in Connecticut has varied widely, from a high of 606,528 square feet built between the first quarter of 2014 and first quarter of 2015, to no space added between the pandemic-impacted first quarters of 2020 and 2021, according to Revista.

Few developers and lenders are interested in pursuing medical office construction on speculation, dampening inventory growth, Martin said.

Current trends are leading to higher rents on existing facilities. Traditionally, 2% annual rent increases were the norm, Martin said, but now landlords are pushing annual increases of 3% or more.

Medical office vs. general office

Philip Gagnon, principal at Colliers International in Hartford, represented the seller of the Torrington medical office property and touted the deal as a counter to the stream of negative news about office space.

The niche medical office market has “soared” to new price levels as buyers are willing to accept lower returns in the first year of their investment, he said.

Gagnon said rising borrowing costs have put pressure on some investors, likely making them more selective. Class B medical space offers more room for raising leasing rates than Class A, he said.

Jay Morris, managing director of O,R&L Commercial Real Estate, said telehealth is a good tool, and was especially useful during the COVID-19 pandemic, but it has turned out to be no replacement for in-person physician visits.

“We are still seeing positive absorption of medical space and rents have been stable and growing, just like the occupancy,” Morris said. “It’s a totally different animal than general office space.”

Morris said some plans for new medical offices are moving forward out of necessity.

For example, construction began earlier this month on a new 48,000-square-foot medical office complex in North Branford, to be anchored by community behavioral health clinic BHcare.

Other discretionary projects are being put on hold in anticipation of future interest rate reductions, he said.

“It’s still a strong segment,” Morris said. “Just because people are not putting up new buildings all the time, it doesn’t mean it’s not stable. And lease rates are still relatively high.”

Brannan Knott, a managing director of JLL Capital Markets, said investors are influenced by an ongoing push to move procedures from inpatient hospital settings to less-expensive outpatient facilities.

“The move is to deliver care in a lower-cost setting,” Knott said.

Insurers and government programs are increasingly interested in having expensive procedures performed in lower-cost outpatient settings, Knott said. Investors are responding by buying outpatient medical office buildings, he said.

Knott was part of the JLL team that brought Sendero and New York-based Angelo Gordon together.

Since that partnership was hatched earlier this year, Angelo Gordon was acquired by San Francisco-based real estate management firm TPG Inc.

Angelo Gordon now operates as TPG Angelo Gordon, a $74 billion real estate investment firm within TPG.

Investors look to medical office space as a safe-haven in uncertain economic times, Knott said.

During the 2008-09 global financial crisis, the U.S. medical office sector experienced only two quarters of shrinking net operating income, Knott said.

At the time, occupancy rates nationally fell from around 92% to 91%.

“We are steady Eddie,” Knott joked. “If you think about it, if you break your arm, you are not going to think about whether you can afford it or not, you are going to seek help, and then you are going to figure out how to pay for it.”

Craig Way, managing director of Greenwich-based HB Nitkin, told attendees at an Oct. 16 meeting of the Connecticut and Western Massachusetts Chapter of SIOR, that his real estate investment company has bought “four or five” medical office properties over the past five years.

HB Nitkin doesn’t compete with big real estate investment trusts on “institutional-quality” medical properties, but focuses on smaller, less amenitized Class B spaces in well-placed markets, Way said.

“We love medical,” Way said. “They say: ‘sticky medical.’ You sign up a tenant for 10 years and usually they are there for much longer than that.”