Once Development Wave Completed, Market Will Pause

• Medical office market sees impressive absorption following development cycle; another 385,000 sq. ft.
  coming on line
• New construction rental rates are pushing into the mid-$20s
• Medical groups jockey for position in anticipation of Maple Grove hospital 

Medical Office Market Remains Healthy

The Twin Cities medical office market boasts strong activity. Only 10.2% of the 5.2 million square feet of space was vacant at mid-year. This market is considerably healthier than the general office market, which is reporting 14.7% vacancy. Six hospital campuses reported virtually 100% occupancy for multi-tenant space. On-campus vacancy was 7.0%; off-campus, 13.7%. The Northwest is the tightest at 6.9%, followed by the Southwest at 7.4%, the Southeast at 15.4%, and the Northeast at 23.3%.

The market absorbed 175,549 sq. ft. at mid-year, the majority in off-campus properties. The 124,000-sq.-ft. Westminster Business Park in St. Paul opened fully leased, which helped boost absorption.

Activity Leads to Development

Robust market conditions have prompted unprecedented levels of new construction. At mid-year, 202,388 sq. ft. of medical office space—all off-campus—was delivered. Another five buildings—a mix of on- and off-campus buildings totaling 385,000 sq. ft.—are expected to be complete by year end. Once this construction phase ends, a pause is expected as the market settles and absorbs space. Future construction will be demand-driven.

Rates Reaching Record Levels

Average net rental rates rose to $17.54, showing an increase every year since 2003. New construction rates are pushing the mid-$20s because of increasing land and construction costs. Higher construction rates are pushing rates on existing buildings upward as landlords try to close the gap between existing and new medical office product.

Maple Grove Is Hot

Demand continues in Maple Grove in anticipation of the $120 million hospital campus to open in 2010 near I-94 and the future Highway 610. The hospital—a partnership between North Memorial Health Care and Fairview Health Services—is the first metro-area hospital developed in two decades, The new campus has 235,000 sq. ft. of medical space currently under construction and more anticipated. Medical groups with appetites to control real estate are jockeying for position near the future hospital. Fairview partnered with University of Minnesota Physicians to staff its Maple Grove Ambulatory Care Center in order to enter the submarket quickly. Ryan Co. US, Inc. developed its Grove Health medical office building on a speculative basis and is expected to be fully occupied soon.

Recruitment Proves Challenging

Medical staff recruitment remains extremely competitive, so staffing expansion clinics is challenging. Drawing physicians to the Twin Cities is difficult when competing with opportunities nationally, where markets offer higher pay scales, warmer climates and further opportunity for growth. Allina Hospitals & Clinics and the University of St. Thomas announced a potential initiative to open a third medical school in Minnesota to train primary care physicians.

Hospitals/Physicians Redefining Relationships

As physician groups continue looking for additional sources of revenue, they are moving traditional hospital services, like radiation and imaging, off campus. However, this impacts hospitals’ profit margins and is forcing continued discussions regarding how physician groups and hospitals interact. Related to this topic, the Minnesota Legislature recently passed a two-year moratorium on the construction of radiation-therapy centers, pending further study.

Investor Interest in Medical Office Remains Strong

There continues to be a strong appetite for local medical office properties by national investors who like these properties for their longer-term leases. MSP Commercial sold two of its off-campus medical office properties to foreign investors in the past six months: the 43,449-sq.-ft. Currell Centre professional building in Woodbury, and the 44,049-sq.-ft. Town Centre Plaza professional building in Eagan. Another noteworthy sale, which closed in late December 2006, was that of the 101,016-sq.-ft. Centennial Lakes Medical Center in Edina.

The Outlook

A pause in medical development will allow the market to catch up. Demand for new construction is slowing as medical users evaluate their real estate needs. Vacancies will increase as the market adjusts to absorb record amounts of new construction.

Physician and medical staff recruitment will be challenging when staffing new facilities and could significantly affect future growth and its timing.

Rates will continue to increase, causing physicians to rethink relocation plans. As physician reimbursements continue decreasing, physician groups may remain in existing spaces rather than pay new building rates. Continued discussions will occur regarding how physician groups interact with hospitals.