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5 ways healthcare REIT sector will change because of COVID-19

Jun 19, 2020

Amid the unprecedented changes wracking the business world in 2020, one certainty remains: many industries will look very different in future years as strategic responses to COVID-19 gain traction and become permanent. In the healthcare REIT sector, we are beginning to see trends that may shape industry norms long after the dust has settled from the chaos of 2020.

1. Conservative Balance Sheets/Liquidity Emphasis

The 2020 pandemic dramatically illustrates the need for corporate resilience. When an unexpected major detriment occurs, a strategic or financial “safety net” can mean the difference between a company’s survival and its demise. Companies that entered 2020 with strong, conservative balance sheets and ample liquidity are poised to weather the storm of business closures, lost rents, increased costs and other pandemic-related crises. 

Some publicly traded healthcare REITs have reported taking steps to build liquidity, cut costs and/or reduce leverage in order to build cash reserves. [1] These strategies enhance nimbleness and flexibility, thereby maximizing options for responding to unforeseen events and sudden detriments. As healthcare REIT executives and investors internalize the lessons of 2020, this general conservatism may expand not only in the fiscal realm, but also in healthcare REIT documents and transactions. For example, it seems likely that leases will contain more specific, detailed force majeure clauses, that transactions will involve more extensive diligence, reps, warranties, indemnities and protections for wary buyers, and perhaps that pandemic insurance (or business interruption insurance specifically covering pandemic-related losses) will become more widespread.

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2020’s new abundance of caution may also lead investors and/or regulators to demand more extensive disclosure and greater transparency regarding health and safety measures. 

2. Occupancy Rate Shifts

Demand for all types of healthcare real estate is widely expected to change as telemedicine expands and more people work from home. While some experts opine that these factors will diminish demand, others believe that will be somewhat offset by tenants who want larger (if fewer) spaces in order to facilitate social distancing. Although the direction and the extent of occupancy rate changes are uncertain at present, many healthcare real estate leaders are confident that past occupancy trends will take downward trajectories in coming years. These uncertainties are another reason why companies are likely to stick with 2020’s trend of caution and conservatism as discussed above.

With respect to occupancy rate changes and shifts in demand, different subsectors of healthcare real estate -- and different geographic markets -- will sustain different effects. For example, some healthcare REIT leaders have noted that the medical office sector has continued to be a more “steady Eddie” asset class than more historically tumultuous property types like skilled nursing during the first half of 2020. Others predict that denser metropolitan areas may sustain greater long-term drops in demand than secondary markets as remote working and social distancing become ingrained in everyday work and life habits. 

3. New Hot Markets

In addition to new demographic patterns that may lead people (and businesses) away from dense markets in the wake of COVID-19, new state and local regulations adopted in reaction to the novel coronavirus will vary. Regulatory differences across the country will -- and already do -- create a patchwork of laws, making business operations in some markets more difficult and costly than in other markets. Although regulations may become more consistent over time as different jurisdictions discover what works well and what doesn’t, it will likely take several years for legislation to become somewhat more uniform, and it is probable that many state and local variations will remain indefinitely because of differing demographics, political composition and market specifics. Some healthcare REIT experts anticipate heightened interest in small-city markets, continued growth in off-campus facilities, and perhaps rejuvenation of transactional activity in rural markets.

4. Changes In Portfolio Composition

Investors are watching public healthcare REIT filings closely for red flags and subtle (or explicit) indications of impending difficulties. A number of publicly traded healthcare REITs have been proactive in disclosing information to reassure investors, and the picture they paint seems brighter overall than the outlook for the hardest-hit REIT sectors (e.g., retail and hospitality). Some industry leaders have pointed out the continued reliability and desirability of the MOB subsector. The life science subsector also has shown indications of continued strong demand and stable rent collection.

Senior housing and skilled nursing facilities, on the other hand, faced headwinds such as oversupply, labor issues, and reimbursement/regulatory risks even before the pandemic, and COVID-19 has hit these subsectors harder than other types of healthcare REIT properties in part because the senior population they serve is at high risk for the virus. However, many believe that despite current woes, brighter days are ahead for senior living facilities and nursing homes due to factors such as the “silver tsunami” of aging Baby Boomers -- a phenomenon that is expected to increase demand and help offset oversupply issues in the senior care industry in coming years. 

Depending on the investment goals and opinions of company leaders and investors, we may see changes in the property mixes and the sectors of emphasis of different healthcare REITs. These portfolio makeovers could be based on reactions to reported metrics (e.g., rent collection, changes in occupancy rates, and changes in costs for the various property types), regulatory changes in particular markets or asset classes, and subjective perceptions or predictions of what will happen next in the healthcare real estate industry. Some companies have already signaled an intention to modify their property mix, either by divesting current holdings to increase liquidity, by reporting interest, confidence, and/or optimism regarding particular asset classes, or by announcing intentional strategies for modifying their portfolio composition.

5. Increased Costs

Healthcare REITs have already experienced a variety of cost increases from COVID-19, and they expect some of those higher costs to continue in years ahead. For example, tenants’ heightened attention to safety concerns, together with social distancing mandates issued by employers and governments, has created innovations in space planning and design. New developments and building renovations are trending toward lower density design with features such as larger elevators, control of airflow between floors, elimination of “bullpen” office configurations, kitchens designed for limited contact, and fully automated fixtures in restrooms. Some buildings may also incorporate technology for performing temperature checks on building entrants. 

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Not only do these new design elements add to development costs, but they also mean that some amenities tenants once found attractive (e.g., food courts, common areas, and fitness centers) lose their appeal. Those once-desirable features may now be detriments rather than marketable components of a building. Likewise, some healthcare REITs expect costs of cleaning, PPE, hazard pay for building staff, sanitation supplies, and the like to remain higher than in years past, though perhaps lower than at the outset of the 2020 pandemic. 

Landlords will probably pass through many of these cost increases to tenants via the operating expense component of rent. However, this pass-through may be a double-edged sword -- it enables the landlord to recover its higher cost, but the landlord may face more difficulty in finding tenants who are willing and able to pay the higher rent rates. Landlord’s effort to recover its extra operating costs may thus present a challenge to occupancy, A/R collection and tenant retention. Companies will need to find a feasible balance between these competing priorities -- a balance which will vary from market to market and which will continue to evolve long after 2020.

Conclusion

Though 2020 to date has been, at best, daunting for healthcare REITs, the industry has a long history of adapting to challenges even when other REIT sectors struggle. Emerging trends in the COVID-19 world will generate permanent change for medical real estate ownership, but unlike sectors such as retail and hospitality, recent healthcare REIT reports overall reflect more optimism than doomsaying. Healthcare REITs that recognize the trends and adopt appropriate long-term strategies should be able to weather the current storm and perhaps become known not only as “recession-proof,” but also as “pandemic-resistant.” 

[1] Recent years have seen several healthcare REITs embark on a path of reducing debt. NAREIT recently noted that companies in this sector entered the pandemic with average leverage ratios lower, and with debt maturities longer, than in the past two decades. The pandemic seems to have accelerated the trend of debt load reduction among healthcare REITs.



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