In the early 2000s, John “JT” Thomas was general counsel for what was then known as the Baylor Health Care System. He spent five years there, assisting in what was one of the first healthcare Real Estate Investment Trusts (REIT) in the Dallas area. Baylor decided to cut a deal with Healthcare Realty Trust, a Nashville, Tennessee-based medical office REIT.
It worked out for Baylor, and proved to be a model that would last in North Texas: Now 15 years later, nearly every major system in the region has an agreement with a REIT, including Texas Health Resources, Methodist Health System, and HCA North Texas are all involved with them. So too are smaller networks, like Forest Park Medical Center, whose operations in Frisco and Southlake are owned by two separate REITs.
Thomas is now president and CEO of Milwaukee’s Physicians Realty Trust, a publicly traded healthcare REIT that focuses primarily on medical office buildings. It manages a portfolio worth $1.4 billion. Last week, I got Thomas on the phone to chat about REITs and what they mean for health systems. It’s been edited for length and clarity.
D Healthcare Daily: So tell me about how Baylor became interested in engaging with a REIT.
Thomas: In 2003, Baylor was looking at its balance sheet and its assets trying to figure out where it might raise some capital. It decided to explore selling the medical office buildings on the Baylor campuses. We ended up doing that with a REIT called Healthcare Realty Trust.
It made a lot of sense for Baylor and it made a lot of sense for the REIT. When I later worked for Cirrus Health, we were very involved in financing and growth through real estate related investments. It’s a huge opportunity. I will say running a REIT is more fun than being general counsel of a hospital, but at the end of the day we’re part of the healthcare delivery system and we think of ourselves that way. I enjoy being a capital provider to healthcare. We help a lot of organizations help take care of a lot of people and indirectly employ hundreds of thousands of people through our clients.
Baylor is a big tax-exempt organization that can raise capital four ways. They can profit from procedures and care, people can give them a lot of money, they can issue tax-exempt debt which is very cheap, or they can sell assets. You look at all four ways as a way to finance the mission and delivery system. Now, for HCA, for Medical City, (for-profits) all four things still apply but they don’t raise philanthropy and people don’t get an exemption for donating. For HCA or Baylor, one of the common ways to raise capital is to sell buildings that house their physicians.
From an operating perspective, paying rent on an annual basis may be more appealing than spending a hundred million dollars on a new building. So when a hospital looks to fund operations and future growth, there is a lot of capital available. They are interested in investing in stable, long-term recession resilient real estate.
That’s what’s unique about healthcare REITs. It’s a very recession resilient business. REITs grew dramatically during the recession because they had capital and people were looking for places to invest. Healthcare proved to be a very safe place to invest and get a nice stable return but not a dramatic, Facebook, stock market type of return.
DHCD: Give me an idea of how long REITs have been used in the healthcare space.
Thomas: For 30 years, from 1970 to 2000, it was a sleepy business. REITs grew and there was some activity, but beginning in 2003 forward it got to be a much more mainstream business. All the REITs, the major REITs today, were all babies then and now they picked up steam and they are huge organizations.
There are three that are the oldest and biggest in the states, those are in the $30 and $40 billion size range. But in 2003 they would’ve been $2 billion to $3 billion. So that’s a dramatic growth.
So there are five different sub categories of healthcare real estate. Hospitals are one, office buildings are two, skilled nursing is three, assisted living is four, and then life science and lab space are five. The big three each own four of the five asset classes and then others are solely medical office buildings.
DHCD: Now, hospitals aren’t like standard office space that can be easily switched to a different use if your tenant defaults on rent. What happens when they can’t pay?
Thomas: One of the reasons why the healthcare focused REITs grew so slowly from 1970 to 2000 is very few people—the investors, Wall Street, folks like that—had any real understanding or spent time or effort understanding healthcare delivery, assisted living operations, things like that. As the REITs educated the market and hired people who understood healthcare, there got to be a broader understanding of how to underwrite and select to buy.
You asked exactly the right question: How do you get comfortable buying a medical office building from Baylor, for example, and what goes into your thinking about that risk profile? Part of that analysis is what do I do with it if Baylor doesn’t pay its rent. Can I replace the tenant can I turn it into something else for an alternative use? Hospitals, on the spectrum of high risk to no risk—and everything has risk—but hospitals and skilled nursing are considered the most risky.
With hospitals, it is very difficult to replace the hospital operator. You can turn the keys over from a Baylor hospital to a Tenet or an HCA hospital to Presbyterian. But it’s a massive undertaking to just turn the keys over to the hospital. And they may not need it. There may be too many hospitals in the market already. Those things all go into the analysis.
Medical office on the risk spectrum is one of the least risky. The thesis is it is an office building that can be converted to general office. Now, that’s not the most accurate assessment, but there’s a perception—and some reality—that it’s a lot easier to convert a medical office building to a general office while hospitals the walls are filled with pipes and very expensive.
The big risk on skilled nursing is not as much replacing the operator as much as it is you’re haggling Medicaid as a source of a revenue. You have 50 governors and 50 state legislatures and the federal government trying to cut and underpay for it. It’s a stroke-of-the-pen risk: one day you’re making $100 a patient and the next you’re making $95 a day and then you have five dollars less revenue. You may not have the money to pay the rent. There are REITs that focus on that and they charge a lot higher rent in exchange for taking the risk for government reimbursement.
Real estate investors, if you’re private, your motivation is how you count your financial success. Is it buying the building, getting it leased, and selling it to me and making it a gain like that? In the public world, we don’t make money buying and selling buildings. It’s more about collecting rent and growing that rent over time and distributing that rent over time through dividends to our shareholders.
The less risky you are on the yield spectrum the lower the yield is you expect. Then, the lower the yield is you can get from tenants.
D Healthcare Daily: You talked about the yields on certain REITs being lower than others. Can you detail that?
Thomas: In today’s market—and this changes based on interest rates—the least risky asset in healthcare real estate is medical office buildings. They’ll typically demand 6 to 7 percent yield on an investment. Sometimes it’s 5 percent, sometimes it’s 10 based on a certain situation. Assisted living falls into that same range as well; you have a huge growing, aging population so the perception in the long term is you’ll be able to keep your assisted living centers full.
Hospitals will get you 7 to 9 percent, skilled nursing will be 8 to 10 percent. Life science is in the 4 percent if you’re in Boston working for Novartis or 8 percent if you’re in Middle America renting to a startup.
The private developers make their money building a building and flipping it to a public REIT. They earn a very profitable return on that by taking that risk on the construction and the lease. When we buy a building, we’re buying it based on the assumption that for the next 12 months we’ll get that 6 to 7 percent yield and increase the rent 2 to 3 percent a year. That’s standard for office buildings. Hospitals you’re getting 8 to 10 percent and growing to 2 to 3 percent per year.
DHCD: So how is the Dallas-Fort Worth market for REITs compared to other sections of the country?
Thomas: Dallas is a very desirable market for healthcare real estate, for REITs. All the major REITs I know have some investment in Dallas-Fort Worth and it starts with several things. One is the quality of the organizations there. You have three, four world class systems there. You have a huge population, a strong economy. All those factors weigh into the attraction of it.
On the other hand it’s so easy to build a building in Dallas, there are very few barriers to entry. So you have to be more selective of what you buy there because it’s so easy for competition to come in and build right next to you. You look at Frisco: a lot of those buildings are medical office buildings built next to medical office buildings that were built five to 10 years ago. There’s a lot of competition because there are very few barriers to entry. Across all the asset classes, REITs, I would venture to say, own billions of dollars of healthcare related real estate in Dallas-Fort Worth.
Now, contrast that with Atlanta, which is our biggest market. In Georgia they have certificate of need laws, so a lot of the buildings in Atlanta, the services in the building are provided under a certificate of need. It’s difficult to move those services out of a building once it’s there. Atlanta, for all the same reasons in Dallas (great health organizations, huge population, relatively strong economy), attracts real estate investment. But in Atlanta you have a different feature in the certificate of need requirements.
DHCD: You mentioned earlier that this is a particularly recession-proof investment. Can you talk about that?
Thomas: We talk about this a lot with investors and Wall Street. So, we’re publicly traded on the New York Stock Exchange. So if you have a dollar to invest, why healthcare real estate instead of a Ritz Carlton? Healthcare in the united states is a $3 trillion business today, it’s going to $5 trillion in 2022. That growth is there almost because of the aging population.
It’s a very stable and growing business. Whereas, you may not go on vacation and stay in a Ritz Carlton in a recession. But if you’re sick, you’re going to go to a hospital. That’s why healthcare in particular has attracted a huge amount of capital, because people were looking for a safe place to invest their dollar.
It’s not that investing in Ritz Carlton’s are bad, it’s about what your goals are. If you want a nice steady return, healthcare investment is a fairly easy place to REIT. The other important point is, Frisco is an example, but Frisco boomed bc of the population booming out there.
Prosper is going be the next one and McKinney, but you have to look at the original hospitals in Dallas that are still operating. Baylor downtown, Presbyterian, Methodist across the river—their core facilities are 50 to 60 years old. As Baylor, Presby, and Methodist think about competing with each other but also reducing cost and adhering to the ACA, they’re saying we can’t tear down this hospital and start over. So instead of tearing out the old hospital and building a replacement, all of those health organizations in Dallas and across the country are putting new outpatient facilities in those markets and making it more convenient for physicians and the patients.
When you’re really sick and you need transplant or trauma, you go to the hospitals that tend to have been there for a long time and transformed internally to serve those really sick populations. It’s a rapidly growing part of the U.S. healthcare economy it’s going to continue to be for the foreseeable future. And that’s decades, not just the next 10 months. We are a good source of capital to help fuel that growth in healthcare services. Generally, every hospital in Dallas has gone to a REIT and sold its buildings to a REIT or leased from a REIT.