(May 16, 2022) - As investors prepare for a potential downturn in the real estate market, T. Andrew Dow of Winstead explains the rewards and risks of expanding portfolios to include health care facilities.

The real estate market has been good to investors over the past decade and a half, and the multi-family and industrial sectors have led the way due to a variety of factors. The cost of housing (especially in major markets), as well as personal choices among younger workers to remain transient, have limited the pool of viable homeowners, leading to an increase in demand for renters.

Likewise, a fundamental shift in retail shopping habits away from brick-and-mortar retail outlets to online shopping has created increased demand for distribution hubs, causing many in the real estate industry to refer to industrial warehouse space as the new retail. The pandemic only served to accelerate these shifts and has increased investor appetite for these market sectors, causing significant compression in cap rates and reducing the value proposition to investors.

In addition, supply chain issues, rising interest rates, higher energy prices, the war in Ukraine and once in a generation inflation numbers have created headwinds that have caused many in the industry to speculate that a slowdown in the real estate market is imminent. Economists' opinions vary on the extent and potential duration of the slowdown but mixing the forgoing ingredients has historically been a recipe for a market pullback.

Despite the headwinds, there remains plenty of thirsty capital allocated to real estate that needs to be placed in the market, and the combination of the foregoing factors has caused many institutional investors to look to alternative asset classes to place that capital.

One favored alternative (if you can even still call it an alternative) is healthcare real estate, where investors still see value at today's prices, but are also attracted to its historical resistance to the normal ebbs and flows of the traditional real estate market. According to healthcare real estate analytics firm Revista, 2021 was a record-breaking year for medical office building activity with transaction volume exceeding $16 billion. A majority of that acquisition activity was led by private equity investors, followed by healthcare REITs. With new institutional investors continuing to enter the market, some have speculated that so much capital flowing into the sector might offset the impact of higher interest rates and allow the velocity of transactions to continue to increase through 2022. In fact, a recent report from commercial real estate behemoth CBRE estimates that total transaction volume in the medical office sector will jump to $25 billion in 2022. Not surprisingly, in its 2022 U.S. Investor Intention Survey, CBRE reported that healthcare real estate is now "the most preferred alternative real estate sector."

Several factors contribute to healthcare real estate being a favored investment in this environment. Perhaps most important, healthcare real estate has proven over time to be stable and remarkably recession resistant. During the peak pandemic year of 2020 while most real estate landlords were modifying leases to reduce or abate the rent obligations of their tenants, healthcare REITs averaged very close to a 100% collection rate in medical office buildings and special-use facilities. To put that in perspective, shopping centers saw rent collections of less than 60%.

Other societal factors also favor the long-term outlook for healthcare real estate. First, the aging baby boomer population is only increasing the demand for healthcare services, which also increases the need for clinical space.

Second, the movement toward population health management and changes brought about by technological advances in medicine and the Affordable Care Act (which now appears to be here to stay) have caused healthcare providers and payers to re-imagine the entire healthcare delivery ecosystem, shifting away from the traditional on-campus delivery model to a more accessible ambulatory strategy. This shift has created the need for new off-campus facilities that are in the areas where the patients work and live.

Third, healthcare tenancies are remarkably stable, yet the tenants increasingly prefer to operate on shorter term leases. While longer lease terms would generally be preferred by most landlords, the shorter terms do provide a hedge against inflation by allowing landlords to more quickly adjust rental rates to market. These and other factors serve to mitigate the impact of any downturn in the broad real estate market on healthcare real estate and make healthcare real estate investment an effective defensive strategy.

To be sure, there are other factors that create a certain level of risk in healthcare real estate investments. The regulatory overlay adds a dimension of complexity to certain transactions, with providers required to comply with intricate Stark Law and Anti-kickback statute requirements.

In addition, advances in medicine have shortened stays in hospitals and rehabilitation facilities, resulting in less demand for beds in those facilities. Likewise, the emergence of telemedicine (which was accelerated by necessity during the pandemic) has reduced the need for office visits, which over time may reduce the demand for medical office space. Despite these countervailing macroeconomic issues, investor appetite for healthcare real estate is at an all-time high, largely because investors view the long-term positive trends as significantly outweighing any negative trends impacting the industry.

Given the surplus of capital chasing a limited supply of available product, many investors wanting to allocate funds to the healthcare sector have been forced to expand their definition of healthcare real estate beyond the traditional medical office buildings to include other types of facilities, such as behavioral health facilities, rehabilitation facilities and even acute care facilities.

However, these "alternative" healthcare investments can be more difficult to underwrite, because their success or failure depends largely on the quality of the operator of the facilities. For investors who are not also operators, the underwriting of the operator becomes perhaps even more important than the underwriting of the real estate itself. If an investor wants to add some of these alternatives to its healthcare real estate portfolio, it would be well served to partner with a best-in-class operator.

Another related alternative product type that is growing at exponential rates and is closely related to the healthcare industry is life sciences real estate. In fact, the increase in demand and relative lack of supply of quality healthcare projects have caused many investors to expand their definition of healthcare real estate to include life sciences facilities. The life sciences industry includes pharmaceuticals, biomedical technologies and many other subcategories involving the scientific study of life. Since many of these fields are closely related to medicine, there are synergies to be found, especially with the large research universities and related health systems.

Notwithstanding the synergies, life sciences as an emerging alternative asset class for real estate is still in its infancy compared to the broader healthcare real estate market. In addition, in terms of real estate, life sciences space can be a distinctly different product type from the traditional medical office building that has come to define the healthcare real estate space. While healthcare real estate is dominated by medical office buildings, hospitals and other clinical space, life sciences facilities can incorporate any combination of office space, laboratory space or even manufacturing space. Recognizing these similarities and differences, it remains to be seen whether life sciences real estate reflects the same stability and recession resiliency as the traditional healthcare market has displayed.

Despite the optimism among investors, healthcare real estate shares some of the risks of the broader real estate market. One issue in particular that is nagging landlords in the current market is inflation. Many medical office building owners who have grown accustomed to an economy with little to no inflation have awakened to the reality that today, without CPI rent escalators in their leases, long lease terms can be an albatross around the neck of a healthcare real estate investment. As a result, many owners are now pushing strongly to include escalators in their leases as a hedge against a loss of value caused by inflation.

In addition, while the investment market in the healthcare real estate space remains robust, supply chain issues have created significant barriers to new development opportunities. Developers that used to be able to rely on firm bids from contractors to create a budget that would support the underwriting of a project now are having difficulty getting contractors to hold prices or commit to timelines.

As a result, developers have a hard time negotiating leases with prospective tenants when they have no idea what the building is going to cost to build or how long it will take to build. This is forcing developers to push pricing on leases to a yield on cost model that protects the developer's downside, but provides uncertainty for the tenant. When the tenant is a healthcare provider, that uncertainty is particularly troubling.

While it may not generate the eye-popping returns that some other asset types experience in the good times, healthcare real estate has proven over many years that it performs well in all cycles. The real measure of healthcare real estate's value comes not necessarily from its upside potential, but from its lack of a real downside. An expanding number of investors have recognized this fact and are investing in the market in record numbers. That certainly bodes well for the future of healthcare real estate, regardless of the general economic forecast.