Medical Office
Key Takeaways
• Tightening economic factors are causing Healthcare systems to slow growth plans
• Leasing remains strong causing some of the lowest vacancy rates for medical office properties in years
• Higher interest rates and construction pricing slow future projects
Capital Crunch
The healthcare real estate sector is facing challenges due to capital constraints, the hesitation of large healthcare systems, slowing development, delayed project kickoffs, and rising interest rates. However, by adapting strategies, exploring alternative financing options, and focusing on niche markets, developers can navigate these challenges and capitalize on opportunities.
Economic Indicators
Historic Comparison
An overall re-assessment of the buildings in the market set created an inventory change greater than new supply delivered.
Historic Absorption, Deliveries and Vacancy Rates
Lease Transactions
Source: Colliers, Costar
Market Pulse
In recent times, the healthcare real estate sector has encountered various challenges that have led to a slowdown in development. Capital constraints, coupled with the hesitation of large healthcare systems, have contributed to delayed project kickoffs and a decrease in groundbreaking activities. Additionally, rising interest rates have further impacted the overall landscape.
Another significant hurdle for healthcare real estate development is the hesitation of large healthcare systems to commit to new projects. Due to financial uncertainties, these systems have been cautious about undertaking new ventures, opting instead to delay or even put projects on hold. Their cautious approach is understandable given the uncertain market conditions, as they prioritize conserving capital and focusing on their core operations.
Despite these obstacles, there are still opportunities to be explored and strategies to be implemented to ensure continued growth and success in this ever-evolving sector.
Supply Delivered and Under Construction (UC)
Vacancy
Vacancy rates have continued to decline to some of the lowest levels in recent history. This is a stark contrast to the dramatic increase in vacancy rates and sublease options available in the general office market. We anticipate more office properties look to Healthcare Tenants as ways to stabilize their buildings.
On hospital campuses, vacancy rates continue to vary dramatically with most campuses at or near zero space available while others see vacancy rates in excess of 15%.
Absorption and Leasing
Leasing of existing medical office spaces has remained very strong through the first half of 2023, especially in the newer and higher-quality buildings. With fewer new properties coming to market with additional vacancy, independent groups looking to expand or relocate are finding fewer options available.
On hospital campuses, leasing has been slower due to the lack of inventory on most campuses. The spaces that are available on select hospital campuses are often in older, lower-quality buildings.
Local Investment Trends
The drop-off of investment sale properties that started in the second half of 2022 continued in the first half of 2023. The dramatic shifts in interest rates and financing requirements have caused the tightening of lending by most traditional lenders. Regional banks who have historically been very active in the capital markets are under tightening fiscal pressure, moving investors to look to credit unions, smaller out-of-metro banks, and alternative markets for debt.
Borrowing costs at or above 6% have continued to push up CAP rates well above 7% for even high-quality medical office buildings. Some core plus assets have seen activity at negative leverage by larger institutional buyers as they see future stabilization of interest rates and the need to place capital, but these transactions are rare.
Source: Colliers, CoStar
Source: Colliers, CoStar
Average Sales Price per SF ($)
Source: Colliers, CoStar
Rental Rates
As vacancy rates continue to drop and interest rates remain high, Landlords have looked to push rental rates and annual escalators. Second-generation medical office rental rates are now over $19 per square foot (PSF) with class A and B buildings seeing asking rents in the low to mid $20s PSF net.
Higher interest rates and construction costs have pushed the newer properties that will be coming available later this year to the upper $20s PSF net. Those projects were started and financed in 2022 prior to the run-up in interest rates. To get many new proposed medical office projects to pencil out, developers are now looking for asking rents well above the $30 PSF threshold.
Overall Rents (NNN) for New and Old Buildings
Source: Colliers, CoStar
Construction
More than 400,000 square feet of new medical office buildings are currently under construction. This is more than the previous two years combined. Most of these projects are in the south and west Twin Cities Metro. Many of the buildings are anchored by outpatient surgical facilities continuing the trend for off-campus surgery centers. Nearly all the buildings under construction will be delivered
Medical Office Building Construction Sites
and opened by the end of the year or early 2024. Several proposed new buildings have been put on hold as the cost of debt has skyrocketed in 2023. We anticipate a decrease in deliveries in 2024, putting more pressure on the already tight medical office inventory.
