A Slow Recovery

Doctors used to wait in line for the chance to rent space in one of Robert Held’s office buildings. The Westwood-based landlord charged as much as 30% more for his medical suites than ordinary office space commanded, and still demand climbed steadily.

The waiting lists of doctors are long gone, and Held Properties Inc., owner of half a million square feet, is vexed by vacant medical offices. Rents still exceed those for general office space, but not by nearly as much.

Held’s situation is far from unusual. He and other owners of medical buildings say it illustrates the dramatic differences between the market for medical office space now and seven or eight years ago, when such buildings were one of the surest bets in commercial real estate.

Demand for space rose steadily because the health-care industry grew every year and doctors tended to sign long-term leases. Space commanded premium rents because doctors require specialized plumbing, heating and electrical systems, as well as specially equipped facilities such as X-ray rooms and labs.

Since most doctors rented relatively little space, small developers and investors could build or buy buildings of 20,000 to 30,000 square feet and easily fill them with tenants who always had money to pay the rent.

But all of that’s changed because of consolidation in the health-care industry.

Although the industry overall has continued to grow, Held says, doctors in his buildings today use an average of 650 square feet of space each, compared with about 1,000 square feet at the beginning of the 1990s. That’s because doctors today tend to practice in medical groups, in which they share receptionists, waiting rooms, examination rooms, nurses, appointment clerks and equipment they formerly maintained separately.

According to industry insiders, the changes in the medical office market are a direct result of the continuing squeeze on health-care costs by the managed-care movement.

“Managed care has had a profound effect on our business,” said Daniel Gottlieb, chief executive of Beverly Hills-based G&L; Realty Corp., a real estate investment trust that owns and operates medical office buildings.

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Only a few years ago, Gottlieb said, it was virtually unheard of for a medical office building to go into default. But the economics have changed in the ‘90s, driving out smaller landlords.

Managed care has changed the fundamentals of the market for medical offices, Gottlieb said. As individual practitioners consolidate into groups to operate more efficiently, he said, the groups need larger suites. That means landlords must remodel buildings to combine smaller spaces into larger ones, an extremely expensive proposition: Remodeling a medical office can cost two or three times as much as remodeling a general office building.

Smaller landlords don’t have the funds to make the changes, and doctors who once shared willingly in these “tenant improvement” costs are generally less willing to shoulder a large share of construction costs because they are making less money under managed care. At the same time, larger medical groups have more negotiating clout and can drive a harder bargain for lower rents.

Gottlieb said the changes have been manageable for large owners such as Held Properties and G&L;, which owns about 900,000 square feet of space in 16 medical office buildings in Southern California.

But the impact can be devastating for smaller owners. An example is Imperial Medical Plaza, a 27,000-square-foot building in La Mirada that went into foreclosure in late 1995. The building was nearly half-empty when the current owner, Union Central Life Insurance Co., foreclosed on the property, said Glen Berryhill, a vice president at Long Beach-based New America Asset Management Services, a property management firm.

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Berryhill said the building, formerly owned by individual investors, was essentially unleasable at the time because it needed about $500,000 in deferred maintenance and other improvements to make it marketable.

The new owner has invested that amount and the building is about 85% occupied, Berryhill said, noting that a substantial part of the investment went into combining four smaller office suites into a space for a medical group.

“Most of the new tenants we are seeing come in are medical groups,” Berryhill said. “When we get individual doctors, it’s usually on a lease renewal.”

Smaller operators can survive in the current market, but doing so is much tougher than it was just a few years ago. Some owners have converted their medical buildings to general office space, Held said, but there is limited demand for the typically small suites.

The high cost of converting buildings is one reason new construction sometimes makes more sense, says Richard Scrushy, chairman of Birmingham, Ala.-based HealthSouth Corp., which is nearing completion of the 90,000-square-foot Kerlan-Jobe Orthopaedic Clinic adjacent to the 405 Freeway north of Westchester.

Scrushy said HealthSouth, which bills itself as the nation’s largest provider of outpatient surgery and rehabilitative services, with more than 1,600 locations in the U.S. and Britain, is constantly evaluating medical office facilities throughout the country.

Many of the older medical buildings “don’t accommodate some of the new concepts in medical care,” Scrushy said.

Broker Craig Meyer, a Seeley Co. senior vice president who represented HealthSouth in the Kerlan-Jobe project, said the market for medical office space “has never really been a high-demand market like the general office market,” but he said the market has been steadier and more reliable because doctors tend to stay in one building and sign long-term leases.

According to Gottlieb, that stability is returning because demand has started to rise, and little new space has been built.

With the worst apparently over and the market apparently on the road to recovery, Gottlieb believes medical office buildings again represent an investment with potential for owners with the wherewithal to adjust to changes wrought by managed care.