Reflecting on the Last Real Estate Cycle…and Figuring Out How to Take Advantage

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Chris RossBy Chris Ross Healthcare Practice Group

Fourth of July barbecues, week-long vacations and sand on the floor mats of our cars. We can now appreciate – especially after the nasty May gray and June gloom – summer being in full swing. I think we can also safely say that the economic (and real estate) recovery is also in full swing. The unemployment rate in San Diego has now dropped to 4.9%, the consumer confidence index is up, and our median home value has reached $506,000 – up 35% from year-end 2011 and within $30,000 of its 2005 peak. Let’s think about how this relates to your office space.

When making real estate decisions – whether on a long-term strategic basis or when analyzing one particularly need or transaction – it is never a bad idea to take a step back and think about the bigger picture. Most of us think about times like now, during stable market conditions, as having just completed a real estate cycle. This is a good time to reflect back on how significantly medical office vacancy, absorption, prices, rental rates and other fundamentals were affected by the recession, why certain areas were affected more than others, how all of this impacts market conditions today, and what this means to your medical practice. Every stage of a real estate cycle creates its own opportunities, so let’s figure out what those are in the summer of 2015 and going forward.

When things fell through the floor in 2008 and 2009, most of the buildings and submarkets that felt the biggest impact were those whose developers had lost sight on some very basic principles. Everything in real estate ties to supply and demand. In submarkets like the Tri-City area and South County, developers found readily available land and got caught up in the buzz that surrounded the growing popularity of medical real estate as it started to pick up momentum in 2006 and 2007. The first couple developers to break ground were able to capitalize on the lack of supply of newer medical buildings and the pent-up demand from physicians who needed to expand or upgrade into better quality space.

But other developers focused too closely on their colleagues’ successes without considering the looming threat of oversupply. Some areas experienced expansions in base inventory (the total amount of property in an area by square footage) of 25-50% over a 3- to 4-year period. In the healthcare community, save for large primary care clinics who occasionally absorb large chunks of space, we do not typically see waves of demand to support this kind of overbuilding. Even areas like Escondido/San Marcos, where the district hospital was relocated from downtown Escondido to a new facility nearly 15 minutes away, there was never a surge in leasing activity. Of course there were plenty of other factors such as the Affordable Care Act, demographics and volatile reimbursement rates that affected healthcare real estate in different communities; but all else being equal, even without an economic downturn, some submarkets had set themselves up for failure.

Areas that were less affected were those that have more dynamic hospital campuses, stronger payer mix and lack of developable land, such as UTC and Coastal North County. These areas of course still felt the impact of the recession – UTC, for example, had multiple traditional office buildings decide they wanted to convert large amounts of office space to medical space – but they were not hit nearly as hard as others.

So again, sitting here in mid-2015, how does this impact you?  No matter where you practice, opportunities are out there and you should be strategizing accordingly.

If you are in one of the areas where overbuilding occurred, medical buildings are likely still in the recovery stages even though other parts of the county have approached or surpassed peak rents and prices. Needless to say, this means there remain great opportunities to buy or lease space at a discounted cost, sometimes with large tenant improvement allowances to help minimize the cost of moving.

Meanwhile, even the healthiest submarkets have their own opportunities. In 2005 through mid-2008, most of our central and coastal areas saw a sharp rise in activity from private practice physicians and medical groups who built out brand new medical space. Most of these physicians signed 10-year leases, which means we will see a greater amount of attractive, fully improved medical office space hit the market over the next few years. This will create unique opportunities of significant savings in construction costs for those who are ready and willing to take advantage.

We are also experiencing an uptick in properties hitting the market for sale now that many sellers feel they’re not leaving so much money on the table, they have a little more confidence about their future and are in a better position to expand or relocate, or they are finally retiring now that their investments have bounced back.

So write yourself a note or put a reminder in your smartphone to spend some time thinking about whether you are in an optimal situation with your lease or real estate.  If your answer is “no” or “not sure”, consider the fact that there are great opportunities out there, regardless of your location or the phase of the real estate cycle. If nothing else, have your broker use those opportunities as leverage to save you money on your next lease renewal.

And whatever your situation is, remember to think big picture. Just because we had an ugly June gloom this year doesn’t mean you should move to Florida.

Sources: Bureau of Labor Statistics, Zillow, JLL Research

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