5 Questions to Ask when Evaluating a Medical Office Building

Investing in medical office buildings (MOBs) is quickly becoming a core investment grade property choice. The healthcare real estate sector, and especially MOBs, offer investors a long-term passive investment backed by a financially strong tenant in a high demand sector.

The challenge facing many investors is in evaluating the purchase. Each medical real estate listing will have their own unique features. Some will have multiple specialties within that one location. Other buildings will have been designed for a specific medical purpose. It can seem intimidating to evaluate the risks in these unique medical properties.

There are, however, several methods to assist a buyer in the purchase evaluation of a medical office building (MOB). Consider these five questions:

Is it a Creditworthy Tenant?

Real estate investors seeking secure passive income often turn to investment grade income properties. These properties are leased by creditworthy national tenants. Credit ratings express opinions about the ability and willingness of a corporation to meet its financial obligations. 

Credit Rating Companies

There are four main companies that provide credit ratings. They are Moody’s, Standard and Poor’s (S&P), DBRS, and Fitch. Each of these companies evaluate and research a company’s financial stability based on financial records, loss forecasting, and debt management. Of these, S&P is considered the most trusted rating.

Medical Tenant Credit Rating

Healthcare tenants that have received a credit rating include Affordable Care, DaVita Dialysis, and Fresenius Kidney Medical Care. Most medical tenants, however, have not received a credit rating, though the affiliated hospital may be rated.

There are, however, other ways to evaluate the purchase of a medical office building.

Who has Signed the Lease?

A core component of the purchase analysis process is to determine the source of rental income. While the medical professionals occupying the building may be associated with a regional hospital, it does not necessarily mean that the lease is backed by that hospital.

The formation of a physician group is a common practice with off-campus medical properties. A group of doctors from different practices come together and will often form a limited liability corporation as their legal structure. While the physicians benefit from hospital referrals, the financial stability of the physician group must be analyzed without the financial backing of the affiliated hospital.

On the other hand, many projects are initiated and funded by a strong regional hospital. Once construction is complete, the hospitals will often sell the real estate to an investor and leaseback the property. In this case, though the building is occupied by a group of independent physicians, the hospital itself is the lessee. The analysis should now focus on the creditworthiness of the hospital.

Healthcare related real estate transactions can involve a wide variety of legal and regulatory issues such as the Stark Law and the Anti-Kickback Statute. We recommend that a healthcare real estate attorney be consulted.

Are they Financial Stable?

Regardless of whether the lessee is the hospital or a physician group, the long term financial viability must be considered. One way to research this is to review news articles and reports that involve the tenant. Look for articles that shed light on hospital performance, lending decisions, expansion, contraction, and mergers. Is there a possibility of closure, restructuring or reorganization? Is the hospital struggling or expanding? Could this impact the property under consideration?

What are the Lease Terms?

An existing lease agreement is perhaps the most valuable component of a medical real estate purchase. Analyzing the terms of the lease are critical. It is highly recommended that an attorney that specializes in commercial leases be consulted to look for any clauses that could impact the ownership risk.

Length

Providing that the tenant is creditworthy, the longer the lease the greater the greater the security. Look for lease terms of 10 years or longer. Because the space is custom suited to the tenant, it is unlikely that they would move to a new location before the lease expires.

Renewal Options

The lease should also contain several renewal options. Buyers should expect lease extensions of five to ten years each. The lease will also contain guidelines for notice and acceptance of the extensions.

Rent Escalations

Long-term leases must also have some sort of rent escalation clause. This will work to keep the rental rate at near market levels during the term of the lease. There are two types of rent escalations – annually and at renewal. Rent escalations timed with renewal options are the most common. You should expect them to be slightly below the annual CPI index.

Level of Net

Another major consideration is the level of tenant responsibility. Investment grade income properties should come with either a triple net or absolute net lease. Triple net leases hold the tenant responsible for all real estate related costs, except structural maintenance. An absolute net lease frees the property owner from absolutely all property expenses and management.

Is there Market Demand?

The creditworthiness of the tenant and the terms of the lease agreement are the strongest analysis criteria when evaluating a medical office building. In the unlikely event that the tenant vacates the building, the property owner must also consider the physical factors that would impact releasing.

Medical Expansion

Is there a demand for this type of medical office space? To gauge this, look at the vacancy rate. National medical vacancy rates are presently at around 8 percent. How does the subject property compare? What is the current and historic vacancy rate? Was the property pre-leased?

How much medical office space is locally available for rent? Is there any current or proposed construction of new medical complexes? Are these pre-leased? As long as there is a solid demand for medical office space, releasing should not create too much concern.

Location and Demographics

Off-campus locations are seeing increased demand because of their high visibility. When analyzing the purchase of a healthcare property, you should have your real estate agent prepare market demographics. The information should include population trends, traffic counts, and surrounding commercial property analytics.

The Most Important Factor

There are many different factors that impact a real estate investment analysis, but in the end, it all comes down to income. A long-term lease will obligate the tenant to remain for at least your holding period. It will also place property management responsibilities on the tenant. Eliminating any variable expenses to the property owner.

So, when it is all said and done, the focus has to be placed on the income stream. Does the lessee have the financial stability to pay the rent? If you can prove that, then you have successfully evaluated the purchase of that medical office building.