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Healthcare Realty deal is latest big medical office buy

A $612.5 million deal by Healthcare Realty Trust Inc. to buy 15 Atlanta properties illustrates the continued popularity with investors of medical office buildings.

The buildings, linked to three not-for-profit health systems, traded at 2018 projected cash yield of 4.9% — an aggressive valuation that rivals the sub-5% capitalization rate in another large recent medical office deal, Duke Realty Corp.'s $2.75 billion sale of 78 properties to Healthcare Trust of America Inc.

Low transaction yields are a sign that buyers are willing to pay more for less rental income. Given recent large deals in the space, healthcare real estate investment trusts that focus on medical office buildings "remain the darlings of the healthcare REIT sector, with nothing on the horizon indicating any level of slowing," SunTrust Robinson Humphrey analyst Eric Fleming wrote in an Aug. 8 note.

Equity investors took note of the expenditure — and Healthcare Realty's accompanying 7,250,000-share stock offering — and sent the company's share price down 2.31% in Aug. 9 trading. Yet in the longer term, upcoming lease expirations in more than half of the portfolio may allow the company to raise rents, gaining investor support, Mizuho Securities USA Inc. analyst Richard Anderson argued in a note.

Market participants said after the Duke deal, in May, that the transaction could prompt other owners of medical office portfolios to consider selling their own properties. In June, Physicians Realty Trust said it would buy 18 medical office properties in eight states in a deal worth a combined $735.0 million.

Reacting to the Healthcare Realty deal in an Aug. 9 note, Morgan Stanley analyst Vikram Malhotra wondered whether there are other large portfolios in the market, and whether medical office properties have been "permanently repriced" into the sub-5% cap rate range.

Malhotra called the Atlanta portfolio a good fit with the company's existing properties, noting that 80% of its buildings are on hospital campuses and total occupancy is 96%. He noted, though, that scheduled annual rent increases in the acquired properties lag planned increases in the company's existing properties.

"How long," Malhotra wondered, "does management think it will take to move the bumps up?"

Anderson, on the other hand, cautioned against pushing rent increases too aggressively. Calling medical office buildings "a relatively low-growth asset class with visible/predictable cash flow," he added that landlords risk overreaching for rent growth to justify high asset prices — a move that could hurt their tenants' underlying businesses.

An extreme example of over-emphasis on annual rent growth has played out in the skilled nursing and seniors housing subsectors, in which many large operators have struggled to afford their annually escalating rent, to the detriment of their landlords, Anderson wrote.

While the medical office subsector looks safe from such a situation at the moment, he added, "we are watching the greed factor."