A slow start to 2018 for medical office

The Greater Phoenix medical office market had a slower start to 2018 following two straight years of significant improvement.

Combined net absorption from the past two years totaled more than 1 million square feet, driving the local vacancy rate down by nearly 300 basis points. During the first quarter of this year, however, there was negative net absorption of approximately 11,500 square feet, which resulted in a modest uptick in vacancy and a dip in rents.

Conditions in the investment market closely tracked property fundamentals during the first quarter, with transaction counts slowing and prices retreating a bit. The slowdown in activity is a continuation of a trend that has been in the market in recent years. Transaction totals peaked in 2015 for traditional medical office building and reached cyclical highs in 2016 for medical office condos.

Prices rose in each of the past two years and the only real threat to pricing in the current market is the prospect of rising interest rates and how that might spill over to cap rates. Current cap rates on investment transactions average approximately 7 percent.

Key Takeaways:

  • Vacancy in medical office buildings inched up 10 basis points during the first quarter, reaching 14.4 percent. The rate is still down more than 100 basis points year over year in both on-campus and off-campus buildings.
  • Rents dipped in the first quarter after trending higher in 2017. Asking rents ended the first quarter at $23.01 per square foot, up less than 1 percent from one year earlier.
  • One drag on rents in recent quarters has been a lack of new supply; newer projects generally come online with above-average rental rates.
  • The investment market cooled during the first quarter, although there have been some signs that the second quarter will post greater activity.
  • Prices inched lower in the first quarter, while cap rates for investment sales remained relatively flat, averaging 7 percent.

Outlook:

While demand slowed during the first quarter of this 2018, this is likely a temporary disruption during an extended run of healthy growth. Net absorption in the medical office sector has been positive in each of the past eight years, with 2016 and 2017 being the two strongest years in that stretch.

Looking ahead for the remainder of this year, two traditional drivers of medical demand— population growth and an expanding employment base—remain in place. Maricopa County has been the fastest-growing county in the country, while employers have also been expanding. Year-over-year job growth has topped 3 percent, or roughly two-times the national rate of expansion. More than 7,000 positions have been added in the healthcare industry.

While the traditional demand drivers for medical office space are firmly in place, development of new medical office space will be modest in the first half of this year before ramping up in the second half. A handful of projects are currently under construction, while other projects are slated to break ground between now and the end of 2018.

The likely result of this current lull in new development should be a modest dip in medical office vacancy over the next two quarters, followed by a leveling off as new inventory enters the market. The delivery of new inventory could also bring a bit of an uptick in medical office rents, which have been slow to gain momentum.