Medical outpatient buildings are well-positioned to outperform

Private commercial real estate continues to mature and evolve. In recent years, investors increased exposure to alternative sub-sectors within the asset class that offer unique demand drivers and the potential to outperform core real estate sectors.

Healthcare real estate, which includes a diverse set of sub-types including medical outpatient buildings (MOBs) has quickly gained investor interest and for good reason.

MOBs driven by several factors

U.S. healthcare spending makes up an increasingly large portion of the U.S. economy. As of the end of 2023, it accounts for one-sixth of gross domestic product (GDP) significantly higher than peer nations. The delivery of healthcare has been steadily shifting towards outpatient facilities for a variety of reasons including convenience and significantly lower patient costs.

Seniors as a share of the U.S. population are expected to grow by 70% between now and 2040, growing from 8% to 12% of the total population, a gain of 18.5 million. ¹ This growth should lead to a substantial increase in healthcare spending over that time as seniors spend about three times more on healthcare than younger age cohorts. ² These highly favorable secular tailwinds present a unique window of opportunity for strong medical outpatient demand.

The medical outpatient sector has historically provided higher income returns and much lower total return volatility than the average sector.³

On the supply side, developers began delaying projects in mid-2022 as construction financing quickly tightened in response to the U.S. Federal Reserve’s (Fed) raising the federal funds rate. Medical outpatient starts have fallen to half of the 2022 level despite the strongest occupancy rates on record and strong demand expectations moving forward.

These trends present a unique investment opportunity in healthcare-centric real estate, as these sectors will grow in importance during the coming decades..

The shift towards outpatient care drives demand

MOBs are benefitting from a continued shift from inpatient hospital care to outpatient care, which reduces healthcare costs overall. Multiple procedures are becoming unprofitable for hospitals due to reimbursement cuts policies set by the Centers for Medicare and Medicaid Services (CMS)

U.S. hospital admissions have declined 15% over the past decade, while outpatient admissions have increased by 10% (Figure 1). Patients have been transitioning to treatment in outpatient settings due to convenience and affordability as high-deductible plans become more prevalent.

Medical office avoids office sector risks

Medical office has typically been classified as a sub-sector of the office sector.⁴ However, unlike traditional office buildings, MOBs are far less impacted by remote working as most visits continue to be necessary in person. From a physical standpoint, medical outpatient buildings require a substantially different buildout, including increased plumbing, higher floor load capacity, ample parking ratios, differentiated HVAC/electrical loads, biohazardous waste removal, and different floorplan.

Additionally, while traditional office buildings attract tenants from a wide variety of industries, medical outpatient buildings are predominantly focused on healthcare providers as tenants. The single target market does present a smaller leasing pool, but has historically benefited the sector, as most developers will not build speculatively, only moving forward with significant preleasing from healthcare providers. This creates a cap on new supply which can be seen from the divergence in vacancy since early 2020 (Figure 2). Today, there is a 620 basis point spread in the vacancy between medical outpatient buildings and traditional office buildings at a national level.

While the traditional office sector struggled to regain footing post-pandemic, U.S. medical outpatient fundamentals hit new heights. Demand exceeded supply for 12 consecutive quarters pushing occupancy to 93% collectively across the Top 50 markets.⁵

Unlike many core sectors,⁶ the medical outpatient sector is resilient through cycles and demographic tailwinds remain strong as the aging population continues to drive demand. Supply remains in check and occupancy rates are near peak levels in most major markets. Construction starts have dropped off considerably over the past year, setting up a potential supply shortage in the medium to long term.

High interest rates delay new developments

Rising interest rates and inflation since early 2022 directly led to around a 50% decrease in construction starts. Construction financing in most cases remains dilutive given the spreads needed to justify the risk profile of new development. Additionally, the average price per square foot for new construction has increased by 27% between mid-2022 and mid-2024, growing from $419 per sq ft to $532 per sq ft.⁷

Historical performance and outlook

Over the last decade, medical outpatient buildings have outperformed overall real estate. The medical office sector had an 85.7% total return over the past 10 years, outpacing the overall index, which gained 77.4% in the same period.⁸ This gain is even more impressive given that suburban office gained just 32.2% and CBD office gained just 6.4% over the same period. Being overweight in medical office during this time would have achieved significant alpha over the typical NCREIF ODCE fund (Figure 3).

A favorable entry point has emerged

Like most commercial real estate sectors, pricing in the medical outpatient sector has reset since the Fed began its rate hike cycle in early 2022, which saw the 10-year treasury rate increase from 1.5% at the end of 2021 to 4.3% as of mid-July 2024. Uncertainty on the direction of future interest rate policy and dilutive debt financing have placed most investors on the sidelines resulting in 12-month trailing sales volume falling 30% below the 10-year average. Since mid-2022, the average cap rate rose by nearly 186 bps, implying a 20% price decline assuming 3% NOI growth on an annualized basis.⁹

Nuveen Real Estate views the current environment as an opportunistic entry point for putting new capital to work in the medical outpatient sector. Given the strong fundamentals in place across most markets, the recent price decline can largely be attributed to rising capitalization rates in response to higher interest rates.

A policy pivot by the Fed, which is expected by fall 2024 would provide the market with more clarity on the direction of interest rates, bringing many investors off the sidelines. Additionally, a neutral or dovish policy would create tailwinds for asset appreciation for investments made today. It will take several years for developers to catch up to demand given the recent pullback in starts. This should set up a multi-year period of fundamental outperformance.