5 Challenges to Medical Real Estate
Medical Real Estate is challenging to invest in if you are not prepared for its nuances. There are less capital-intensive, less specific niches of real estate. While medical properties can high-quality asset type in theory, without appropriate preparation and expectations, they may not be high-quality in practice.
On the bright side, the significant barriers to entry make the niche highly defensible. If you have the capability to get in, you will enjoy less over-crowding of the market than you might in a more popular, easier-entry asset class.
Medical properties require more than entry-level capital. A quality building large enough for more than one doctor is going to cost at least $500,000, and probably in the $1-5 million range. For most individual investors, that is too much capital to sink into one property and it makes diversification across properties challenging. One of several effective ways to approach this problem is to form a partnership. With a group of 5 all willing to pitch in $200k you could get a $4 million building. For passive ownership, there are many pooled-capital vehicles that will invest your money in medical buildings—syndications, private funds, REITs, etc.
Very particular tenants
Medical tenants have specific needs and preferences that you will need to understand in order to be an effective landlord. There are licensing codes and HIPAA restrictions they need to comply with, and you may need to facilitate this happening. Decision making within the physician group may be shared among so many doctor-partners that consensus is hard to reach and decisions are slow. You can help their business thrive if you understand how to support physician tenants.
It is particularly important to find a medical tenant with a well-run business. The current trend is towards consolidation into large multi-specialty groups. The practices partnered with national management companies, healthcare groups, and large, multi-location specialty groups will generally have more operational resources than small, owner-led practices. These smaller private practices can still be excellent tenants for an investment property, but many of these are managed and run by the doctors themselves. A practice without at least an office manager on staff will not be conducive to Triple-Net leases and is best avoided.
High absorption tenant improvement cost (TI’s)
Medical tenants don’t move often in part because there are very high replacement costs ($240-300 per square foot) for medical office space…but at some point those costs have to be paid. There will inevitably be a negotiation over who pays for what. If you can front the absorption costs, it will be helpful in attracting tenants and securing top-quality leases. Physicians leave training with tremendous debt but tremendous earning potential, so many physicians seem to prefer to pay higher lease rates than front the TI costs.
High general demand but low turnover
One of the huge perks of medical real estate is that tenants rarely turn over. It would be strange to have a medical tenant outfit a space just to leave after 5 or 10 years. However, that means at any time there may not be many physicians/physician groups looking for new space where your property is located. If you are trying to attract tenants, you will need modernized space at a good price, and you will likely need to connect with a specialized broker or relationships within the local physician community. You can convert the medical space into general office space, but it will rent for less, and you will lose the benefits medical tenants bring. It’s generally best to have a tenant already in place or to have a signed a lease subject to satisfactory completion of tenant improvements.
If your medical tenant does not renew at the end of a lease, you will be left with highly specialized space that will need to be at least partially redone even if the next tenant is also a medical practice. If you shift away from medical tenants, rent will decrease.
This highlights the importance of understanding intrinsic real estate value. Space near a hospital, in a community without many medical facilities, in affluent areas where healthcare reimbursement is higher, etc. are all good ways to increase your chances of releasing to a medical tenant quickly or at least to another tenant that wants to benefit from being close to a medical campus.
Medical real estate offers great opportunities for stable cash-flow, but it is best approached with caution. Ideally partner with someone who has first-hand experience investing in the asset class or with a physician who can help navigate the nuances of the tenant needs. Once you are established and understand the tenant base, it can be an excellent stable-income vehicle.