The Woodlands medical office building market

BY HENRY HAGENDORF, CCIM, LEED AP and BETH YOUNG, CCIM, LEED AP, Hagendorf- Young Commercial Property Services

In all aspects of city and community lifestyles, The Woodlands is a beautiful, vibrant and upscale master planned residential and business community. The city covers over 28,000 acres with a growing population of slightly over 100,000 and a very impressive median household income of $91,000.00. Its healthcare community includes some of Houston’s finest hospital providers including St. Luke’s and Memorial Hermann. Some of these hospital s are architectural masterpieces and appear more in keeping with an upscale vacation spot with lakeside views, than the traditional plain and uninviting hospital environment of years past. In keeping with the success of the overall community The Woodlands boast a healthy medical office building (MOB) inventory of approximately 1.2 million square feet of Class A and B properties including at least two buildings under construction and being preleased.

A recent survey was conducted to evaluate the health of the upper class category of the MOB market. Twelve buildings were selected based on quality, location, ownership and management. Some of the study group was located on or adjacent to a hospital to analyze advantages to this proximity. While the results are not surprising they do reflect and confirm a MOB rental market space that has solid underpinning with a strong foundation and sustainable future. The twelve subject properties total 740,599 square feet and average an impressive 94.5% occupancy without the two properties under construction. The market is so strong that tenants occasionally will take more or less space than they had planned on leasing because of the lack of available space. Tenant representatives and leasing agents that specialize in The Woodlands state that it is clearly a landlord’s market resulting in fewer incentives being offered by the landlords and allowing the Landlords to choose tenants with stronger financial statements, demand higher rental rates and negotiate beneficial lease terms.

Rental rates in this market are quoted in two ways which allocate the operating expenses differently. The base rental rate that is net of operating expenses is categorized as a triple net or “NNN” rental rate. The term “triple net” refers to a rental rate that does not include operating expenses that are incurred in a commercial property, but are passed through separately to the tenants on a pro-rata basis. These operating expenses include property taxes and insurance, utilities (in most cases unless directly metered to the tenant), maintenance and management services. The base rent that is quoted inclusive of these operating expenses is categorized as a “gross” rental rate. The majority of the leasing agents in The Woodlands quoted NNN rental rates ranging from $18.50 to $24.00 per square foot per year. To evaluate a tenant’s full rent you have to combine the base NNN rent with the tenant’s pro-rata share of operating expenses. Operating expenses quoted in the market ranged from a low of $9.00 to almost $13.00 per square foot per year. When the operating expenses are combined with the NNN rates, the resulting rental rates for this submarket range from $27.50 to $33.00 per square foot per year. The quoted gross rental rates (inclusive of operating expenses) were $23.00 to $33.00. Regardless of the methodology used, NNN or gross rates, the end result should be very close.

Typically a landlord is willing to offer a tenant an allowance to pay for all or part of the improvements needed in the space for the tenant’s occupancy. In the MOB environment this is very expensive because of the construction characteristics needed for the practicing physicians. These construction contributions must be covered for the landlord in the rental structure over the term of the lease. The cost of construction for a medical office practice can range from $30.00 to over $60.00 per square foot depending on the condition of the space. For a medical office that is 5,000 square feet, the cost for interior improvements could range from $150,000 to $300,000. It is important to remember that the contribution made by the landlord for these improvements will be incurred up front before the tenant moves in. The landlord then recovers these expenses over the term of the lease.

The Woodlands survey clearly indicates that the various landlords are very willing to invest in the tenants that office in their buildings. The survey indicated that the quoted tenant improvement allowance quoted by the landlords ranges from $5.00 per square foot for space that requires very little renovation because of a previous tenant’s occupancy, to $60.00 per square foot for spaces in buildings under construction. The average quote for tenant improvements ranged from $10.00 to $20.00 per square foot for a five year lease to $30.00 to $40.00 per square foot for longer - seven to ten year leases.

The MOB market in The Woodlands can be summarized as follows:

• Occupancies are high, in the mid-90% range

• The market favors the Landlord who can be stubborn and aggressive

• Rental rates will remain high with upward pressure

• Tenants need to understand how the expenses are factored into the rent

• Tenants may have to contribute to the build out of the space they lease

Anyway you look at it, The Woodlands is a very desirable place to live and work. And these conditions confirm it.