Andrew Dick: Hello, and welcome to the Healthcare Real Estate Advisor podcast. I’m Andrew Dick, an attorney with Hall Render, the largest healthcare focused law firm in the country. Please remember the views expressed in this podcast are those of the participants only and do not constitute legal advice. Today we’ll be talking about valuation trends in the healthcare real estate industry. Hospitals, healthcare providers, and investors are always looking at different ways to value healthcare real estate assets. Typically, a real estate appraiser with deep healthcare real estate experiences needed to competently complete a healthcare real estate valuation assignment. VMG health is one of the leading healthcare valuation firms in the country. Today we’ll be talking with Victor McConnell, a director of real estate services with VMG Health. Victor, thanks for joining me.

Victor McConnell: Thanks for having me Andrew.

Andrew Dick: Victor, before we jump in to some of your valuation work, tell us a little bit about yourself, where you’re from and your educational background.

Victor McConnell: Yeah. I grew up in a small town in Texas about an hour east of Dallas, Greenville. I went to Undergrad at Dartmouth College in New Hampshire, was a English creative writing major, the classic trajectory from Small Town Texas to Dartmouth to healthcare evaluation.

Andrew Dick: Earlier in your career you started working a night shift at a hotel and in Telluride. What was that like? How did you end up there? Tell us about that.

Victor McConnell: Again, that’s the classic… that’s a classic pathway to get into a career in healthcare real estate valuation. After college, I was bouncing around. I got into climbing a lot of rock, climbing and ice climbing and such. I was living in Telluride working odd jobs and eventually had a bad skiing accident and broke both legs in ’05 and needed a desk job. That slowly led to me getting an internship with a commercial real estate appraisal firm that happened to be doing a lot of work for CVS drug stores. Over the years I got further into commercial real estate and did more and more work in the healthcare sector and joined VMG as a consultant initially in about 2012, and then a full time as VMG was building out their real estate practice in 2013.

Andrew Dick: Victor, tell us a little bit about VMG health. I mean, I’m familiar with the company. It’s one of the leading valuation firms in the healthcare space, but talk a little bit about the scope of services offered by VMG.

Victor McConnell: We were founded in 1995 by some ex Ernst & Young partners doing healthcare business valuation and originally valuing everything from the physician practices up to entire health systems. Over the years VMG grew and added service lines, added what we call PSA, the valuation of Physician Compensation Arrangements, other contractual agreements, added capital assets in real estate in the 2000s. Now we’re one of the… if not the largest multi discipline healthcare evaluation firms, so a kind of a middle of the road transaction that engages all of the VMG service lines or core service lines as; hospitals acquiring a physician group, physicians who are going to become employees post transaction, what’s the fair market value of the business and the intangible assets, what’s fair market compensation post transaction and what’s fair market value on either lease or purchase basis for the real estate and the equipment. Then we ensure that all those pieces and the various assumptions fit together in the evaluation.

Andrew Dick: Victor, I’ve worked with you over the years and then I know you have a lot of experience in the real estate space. Tell us about VMG’s real estate practice. Who are you working for? When I worked with you, you were typically working with a hospital or healthcare system, but I know that you’re doing a lot more than working with healthcare providers.

Victor McConnell: Yup. Our core clients tend to be hospital systems but over the years we’ve grown our presence and have worked with a lot of REITs and real estate… healthcare real estate focused private equity firms, lenders, assisting them with their underwriting, trying to get their arms around risk on a particular deal. Sometimes a typical appraisal for a loan or a market rent study. Then we’ll work on litigation related assignments where there’s a dispute that involves value and then the compliance driven work for health systems or on the operational side, private equity buyers that are acquiring healthcare businesses, which is anybody in healthcare right now is very aware of that trend. There’s an increased need for quality of earnings, which has been a growing area of practice for us as a firm. That type of work is driven primarily by the activity in the PE market.

Andrew Dick: So when you’re on those type of projects Victor, you’re testing the income assumptions on the business that will be in the space.

Victor McConnell: Yeah, pressure testing the EBITDA as it were going through, and there’s varying levels of scope. On a real estate focus, we wouldn’t really call that a quality of earnings. Typically that’s more of a… maybe it kind of QOV light or where we’re benchmarking some key risk factors. A true business QOV is a pretty in depth time consuming process where you’re going line by line through a businesses projected revenue and expenses.

Andrew Dick: Victor, valuation, opinions really run the gamut in my world. Some are really light in terms of supporting information. Some have a lot of data. What I found over the years is that healthcare real estate valuation data is closely held. Typically, you can’t hire a local appraiser in a certain market who’s a generalist to value a hospital a or an LTAC or behavioral health care center, just because they don’t have access to that kind of data. That’s always been my assumption based on some of the work product I’ve gotten back from a generalist. Is that true? Talk a little bit about how just the data that VMG has is really what makes it a powerful partner for powerful resource for folks looking for valuation information.

Victor McConnell: Yeah. I’m obviously biased here, but our core compliance driven valuation work across service lines allows us to build up a pretty robust internal benchmarking data set. W annually publish a free study called the Intellimarker that’s a benchmarking study focused on the ambulatory surgery center industry that anybody can download. That study is made possible by our core valuation work. Similarly, on the real estate side, all of the work that we do in our other service lines allows us to get information about transactions and about real estate prices and rents that may not be available from subscription databases like Costar, Inner Vista or other public record sources.

Andrew Dick: Well, Victor, let’s talk about some trends in the industry. Recently you wrote an article about micro hospitals that was published by Becker’s hospital review. Tell us a little bit about your experience working with the micro hospitals, the valuation trends. What’s going on in that kind of sub sector of healthcare real estate?

Victor McConnell: We’ve seen a lot of activity there. Part of this continued move away from the large hospital campuses and the fragmented delivery system that’s a recurring theme. If you listen in on any healthcare real estate conference panel or all of your competitive podcasts, I’m sure Andrew, the… So I think micro hospitals are a manifestation of that. They’re relatively new delivery type that there’s not necessarily even a clear definition of what a micro hospital is. There’s a pretty wide range in terms of size and in terms of services being offered and the cost, the per unit cost per bed or per foot cost can be quite high. When we’ve done work on the behalf of investors who are looking at them, they really wanted to get comfortable from a due diligence perspective because the… on the real estate side, the downside, the dark value on those can be pretty significant.

Andrew Dick: Victor, talk a little bit about how investors look at the micro hospitals. Are these considered a riskier investment in terms of how they’re priced? I think recently there had been some CMS regulations that are focused on micro hospitals and length of stay and-

Victor McConnell: I know Hall Render put out a news blast about that. Do you want to give our listeners a quick overview of the length of stay?

Andrew Dick: Well, I think just briefly. I think CMS has said that you actually have to have in patients with an average length of stay of a couple of days. If you don’t that could potentially jeopardize your hospital status. But victor, how do the investors look at this?

Victor McConnell: Well, I think if you don’t have an ADC and if you don’t have a census of two at the time of the survey, then yeah, you can lose that hospital licensure. In my experience, the way that investors have looked at them is really relying on their operator partner. Given the potential riskiness of the asset, they may be do more due diligence around what the operator is projecting than they would on an asset that’s been around longer, like a surgery center. So, what does that look like? It might mean that you’re doing a deeper dive around the payer mix, and the capture rate and the various volumes that are being projected in the market position of the facility to see if what’s being projected is accurate and realistic because the rental rate that they’re going to be paying the real estate investor can be again quite high. So, they want to know… they want to have comfort that they have a healthy rent coverage ratio.

Victor McConnell: Then in addition to that, I mean, a lot of them are done with credit rated entities. In those cases, the investor is going to look at it maybe a little bit less facility specific if they’re getting a good credit rating behind the lease.

Andrew Dick: When you talk about partnerships or the credit rating of the tenant, it’s been my experience a lot of these micro hospitals are joint ventures between maybe a national for-profit, micro hospital company and a local healthcare system that agrees to brand it with their name. Is that what you’re seeing as well?

Victor McConnell: Yeah. I’ve seen that structure probably I guess most commonly. Although, I think there is some variation there. But without actually being involved in really in the weeds, it’s hard to know sometimes if you haven’t… on some of them that we didn’t work on directly, I only know what’s available in a transaction overview that’s published by some real estate publication. But I’d say my general experience is lined up with yours.

Andrew Dick: Victor, moving away from the micro hospitals, you and I wrote an article a number of years ago for the American Health Lawyers Association that was called, on-campus medical office buildings is a premium warranted. We thought the article was timely because, one, from a valuation perspective over the years, investors in the healthcare real estate space tend to distinguish between on-campus versus off-campus. We also thought it was timely because from a regulatory perspective, if stark or anti kickback applies, there’s some guidance that suggests that proximity maybe shouldn’t be taken into account in terms of setting the rental rate if two providers are entering into a lease, for example. Talk a little bit about the evolution of on-campus versus off-campus from evaluation perspective. It seems like there used to be a widespread in terms of valuation for an on-campus asset versus off-campus, but that may not be true today.

Victor McConnell: Yeah. A big part of the impetus was as you said, a reaction to I think… I think you and I had both seen other attorneys and appraisers who had said, “You can’t charge a different rate because something is on-campus, because of the language around proximity to a referral source.” When I looked into the issue, ultimately I disagreed with that contention for reasons that are laid out in detail in the article. You can observe in the data some of the differences in how the market prices on-campus versus off-campus assets historically. Then you can also walk through some of the physical differences with an on versus off-campus building that you have a amenities often with on-campus buildings, that if you build up a return on cost model would be accounted for, things like a sky bridge or parking deck or access to hospital cafeterias or common space that an off-campus building might not have. Then you have the… sometimes elevated construction costs or higher land value.

Victor McConnell: Again, that will show up if you do a return on cost analysis and then a supply constraint in a lot of cases around a hospital campuses. That now that being said, I have seen cases where the rents on a hospital campus were actually lower than the average off-campus in rates in a given. That was because it was a hospital that had an oversupply of medical office space and it was a… had poor financial performance. So physicians didn’t want to be located on that hospital campus. The larger trend over time has been that the spread and cap rates or the pricing difference between on and off-campus has shrunk over the course of the last decade or so, and more health systems have strategic off-campus assets that are larger, have a wider array of services, that had some specialty build-out or space that’s located in high visibility retail settings.
Victor McConnell: As the real estate investment community sees those trends, they say, “Well, maybe actually the risk associated with this off-campus asset is lower than the one that’s on an aging hospital campus that we’re not sure what’s going to happen too.” That’s a long rambling answer that can be followed up by a review of our HLA article.

Andrew Dick: Now that’s a good summary though Victor. I think in short from the healthcare lawyers that are listening, the bottom line is that in some cases there may be a premium that is warranted for on-campus that can be justified for legitimate reasons outside of proximity to referral sources.

Victor McConnell: Yeah. It’s not a unilateral adjustment that, okay, every on-campus buildings should be X% of an off-campus building. No, that’s not correct. But it is a case by case basis and sometimes the premium is warranted. So ultimately be the answer that I give is the classic answer of the appraiser or the analyst is, it depends.

Andrew Dick: Well, that’s an interesting discussion and if our listeners want to learn more, feel free to go to the show notes and we’ll post a link to the article. Victor, moving on to other unique characteristics of healthcare real estate, we often see ground leases involved, for example, when a hospital wants to develop a medical office building on their campus, hospital may say, “I want to retain fee title or ground lease the land to a developer or physician group who develops the MOB.” What are you seeing in terms of trends? I mean, are hospitals still… do they still like the ground lease model? I think they do. If so, what are you seeing in terms of valuation trends?

Victor McConnell: Well. Ground leases are interesting in that in a lot of cases the dollars associated with the ground lease can be relatively small compared to the total dollars in a deal when you have 50, 100 million dollar construction projects and the annual ground lease payment may be fairly small. But there’s still a significant consideration in it is a 50 to 75 year term. In a lot of cases, ground leases will cover a long list of property rights that can affect what a health system can do with a real estate asset down the road. Sometimes they have put options or purchase options or use restrictions. Those things sometimes have a value impact and sometimes they don’t. I think that health systems who choose to own their own real estate will often still pursue a ground lease structure.

Victor McConnell: I know we’ve seen credit tenant lease agreements and some health systems buying back real estate in kind of a reverse monetization. But generally speaking, I think that the ground leases is still just as prevalent as it was five or six years ago when you’re looking at new on-campus development. The way that I think about ground leases in the context of a new development is always what are the various parties, if you have physician investors, if you have a developer, if you have a hospital and they’re all contributing various things to a development. They may be contributing land or capital or site improvements for the host campus or a portion of a parking garage. You have to look at the development holistically as a valuation professional and determine that all of the various parties are getting a fair market value return on the assets that they’re contributing to the development.

Andrew Dick: Yeah, that’s a good summary. I mean, Victor, over the years when I’ve worked with appraisers that don’t do a lot of work in this space in terms of valuing ground leases, I’ve had… it seems like a wide range of opinion. Some appraisers have said, “Well, under a ground lease, you have most of the tenants. So the owner of the improvements, it’s unlikely that the ground lessee will ever default, because if they do, they could lose the improvements in some scenarios or they know the ground owner knows that the ground lessees lender might step in to ensure that there’s no loss of improvements.” As a result, some of the appraisers have said, “Well, we tend to believe that it’s such a low risk investment proposition that it should be valued differently than a traditional lease. How would you respond to that?

Victor McConnell: Well, a ground lease does have a different risk profile than a building lease. If you look at returns, ground lease rates of return are going to be below a improvement. Part of that has risk, and part of that is that improvements depreciate and land does not. So if you acquire a ground lease, it is an asset that continues into perpetuity. I would say that there is a lower risk profile but it shouldn’t be zero or it shouldn’t be a number close to zero. It should be commensurate with what we see ground leases trading for in the market. There is market data available in the ground lease sector. Actually, a year or two ago there was a wreath that was launched that focuses on ground leases as well.

Andrew Dick: I think you’re right. I was going to ask you about that. I think the ticker symbol was SAFE, S-A-F-E, and they focus on assets that… ground lease assets. I’m not sure how many health care properties they have, but-

Victor McConnell: I personally haven’t seen. I don’t know if they own any or not. I haven’t gone through their 10 k’s or… and I haven’t anecdotally run across any on-campus assets that… or anything like that they’ve acquired.

Andrew Dick: Okay. Victor, as we wrap up here, talk about the future of healthcare real estate and valuation trends. What do you predict in the future? It seems like valuations, for example, MOB assets right now seem to be at an all time high for products that have credit tenants. But what do you predict over the next few years?

Victor McConnell: Well, I’m a skeptic, personally and professionally. Humans in general are not great at predicting the future. In early 2008, I think the global survey of economists forecasted global GDP to grow 2%, and we had the worst recession in 75 years. So anything I predict, I don’t… I wouldn’t put a lot of stock in it. But I think that all of that said, with that significant caveat, I think seeing healthcare real estate continue to become a more recognized asset class, having a larger buyer pool, foreign capital that’s investing in impatient assets and large portfolios, institutional funds, sovereign wealth funds, all of these things have… that didn’t exist in healthcare real Estate 10, 15, 20 years ago are growing. They’re going to continue to grow. I think the cap rate as compared to other core property sectors to apartment, retail, office, industrial, those will continue to compress.

Victor McConnell: I think some select surveys had showed core medical office properties trading at very close to office. It depends on what segment of the market you look at. Simultaneously, healthcare will just… healthcare real estate and… will continue to get more complex, more fragmented, more different types of properties. If you think back 50 years we had a nursing home, a hospital and a doctor’s office. Now we have EL Tags, ASCs, ALFs, Sniffs, SELFs, MOBs, on-campus, off-campus,-behavioral health.

Victor McConnell: Behavioral health, cancer centers, proton centers. Even if you bring up behavioral health, which is one we get a lot of inquiries around, that alone is a very broad term, running the gamut from quasi residential houses up to full scale steel frame psychiatric hospitals. It’s all behavioral health, but very, very different real estate assets, different reimbursement models, different business models. I think that, that again speaks to the complexity of the healthcare real estate market. One of the things that makes it unique relative to some of the other property markets is the… how the business and the real estate are inextricably intertwined. If you’re an investor, you have to understand the business on some level to invest in it. Part of that business is the regulatory risk, which is a lot of what drives your work and my work. Certainly, I’m sure you saw the DOJs 2 billion in recoveries for last year for the ninth straight year. I think that’s the other trend that looking forward is not going to change, the continued regulatory scrutiny.

Andrew Dick: Victor, you recently published an article called Financial Feasibility and Speculative Medical Office Building Construction, where you talk about some trends in the industry where we’re starting to see more specs space being built. Tell us a little bit about your article and some of the work you’re doing around the speculative MOB space.

Victor McConnell: Yes. Financial Feasibility and Speculative Medical Office Building Construction, not exactly a war and peace of titles. It doesn’t really roll off the tongue there. But, yeah, I think part of the… some of the other trends we’ve talked about, the growth of the sector, growth of the buyer and investor pool has led some developers to say, “Well, maybe we can build space at a given location on a spec or speculative basis where we don’t necessarily have tenants pre committed and we’ll lease it up just like we would with office or retail.” That’s something I don’t think happened very often 10 or 15 or 20 years ago because the perceived risk was higher, TIs, the build-out cost for medical office space was higher and so people just stayed away unless you had a tenant who came to you and said they wanted a certain space.

Victor McConnell: But now, we’ve been involved in some projects that were mixed use developments or other off-campus developments where someone thought that medical space would be viable. So then you have to figure it out if it is viable or not by doing some market analysis and some feasibility analysis. That was the purpose of my article.

Andrew Dick: Victor, I mean we’re… some folks say we’re nearing the end of a real estate cycle. How much spec space is really being built? I don’t see a lot of it, but are these developers that have a lot of experience or are they folks that maybe don’t have a lot of experience that are taking a flyer on this?

Victor McConnell: I think that the medical sector is a little bit different. Well, obviously healthcare real estate is affected by the larger kind of real estate macroeconomic forces, and is certainly affected by the real estate cycle. There are also these other factors that are unique to healthcare real estate that the hospitals and patient care, that continues to grow unabated, accompanying population growth and an aging demographic. So the need for space to treat people, even if you have a real estate market that’s declining, that still exists and there’s only so much shelf space that could be converted to medical from something else. I think that the range of people building it, some are more sophisticated than others, but I think that they are responding to a real need in the market, a need for off-campus space and in areas where there’s demand for certain outpatient care.

Andrew Dick: Victor, thank you for being on our podcast today. How can folks connect with you, reach out to you?

Victor McConnell: Our website is vmghealth.com. My email is victor.McConnell@vmghealth.com. But I’m not a hard man to find. If anyone wishes to get in touch, they can find me via VMG’s website.

Andrew Dick: Thanks to our audience for listening to the podcast on your Apple or Android device. Please subscribe to the podcast and leave feedback for us. We also publish a newsletter called the Healthcare Real Estate Advisor. To be added to that list, please email me at adick@hallrender.com.