The impact of US inflation and interest rates on medical and commercial real estate

‘All in all, we’ve acquired $400m-odd worth of medical offices over the last eight years’: OrbVest COO Justin Clarke.

CIARAN RYAN: OrbVest is a global real estate company, and it allows investors from around the world to invest directly into US commercial properties, specifically medical real estate. Why medical real estate, and why the US? Well, we’re about to find out. Medical real estate, it turns out, is about as rock-solid as you can get in commercial properties.

We are joined by Justin Clarke, chief operating officer at OrbVest. Justin, we’ve spoken before about OrbVest and around a unique offering in medical real estate in the US. Thanks for joining us again.

When we spoke previously, OrbVest was generating returns of 2% a quarter from medical real estate in the US. You had properties in Texas, Georgia and New Jersey. Is that still the case or have you expanded from there?

JUSTIN CLARKE: Thanks for having me on again, Ciaran. We just worked out before the call that the last time we spoke was in 2019. So a lot has happened since then, certainly. But as far as 2021 was concerned, that was big.

We acquired 10 new buildings, which is a record by quite a long way.

Apart from Texas, Georgia and New Jersey that you mentioned, we got some good traction in Florida, where we’ve been trying to get in for a few years. We acquired a building in Tampa and Jacksonville – for anyone who knows Florida, two really, really hot spots that are growing phenomenally. I think that’s a great story. Certainly, Texas, Florida and Arizona are gaining a lot of inhabitants. People moved in there because of the, I’d say, well-run states, low taxes and all the rest.

Then, talking about Arizona, we also acquired two buildings. In fact, we’ve got a third one lined up for this year that I hope we can talk about in a week or so’s time. And then we had one in New Jersey, as you mentioned, and we managed to acquire the one right next door. So those are the Princeton Buildings, which, if we put them together, consolidate into a really a nice little portfolio of medical office buildings.

Right at the end of the year, we got two buildings in Cincinnati, Ohio. Ohio wouldn’t be a state that we’d normally go for because it’s a low-growth state, but Cincinnati is fascinating. It’s one of the cities, can I say, in the sort of middle region of the US that’s growing very, very well because of, I guess, good fundamentals.

All in all, we’ve acquired now I think $400 million-odd [worth] of medical offices over the last eight years, which is actually a huge number. If you think about it in rands, it’s about R6 billion. Then we sold some of it. We’ve exited at the end of the five-year periods. So not all of it is still under management.

But overall, I guess [with] some of our lower-performing buildings, our blended returns answer your question and answer them at about 7.3% cash-on-cash over the last two years. So, it’s still pretty close to 2% per quarter on average.

CIARAN RYAN: US inflation is now at 7.5%, and astonishingly that’s quite a bit higher than in South Africa. Who thought we’d see that day? But what does that mean for medical real estate in the US?

JUSTIN CLARKE: Wow, it’s absolutely crazy, Ciaran. If you think about it, one year ago it was about 1.4% inflation in the US, and in 12 months it’s ballooned by 434%. That’s insane. But we all know why.

CPI [consumer price index] is even more scary. The crazy thing is that used cars rocketed 40.5% in price over the last 12 months. Who would have said that investing in a vehicle would beat your equity portfolio, but that’s how it is – absolutely crazy. We know what the reasons are, and I suppose we are not here to talk about that today. But I think that when the supply chains normalise, the general consensus is that these inflation numbers will kind of recover.

GDP growth in the US has also been helping. That’s about 4.6% expected for the year 2022. So the economy is still super, super strong and, yeah, I’m a bull on the US. I guess interest rates will follow. There’s no doubt about that. To answer your question about how this affects commercial buildings, the Fed will try and slow inflation. It must increase interest rates and they have already been pulling back on quantitative easing.

So, I suppose before we get into commercial real estate, you must look at what’s happening to the equities markets. This is getting into your space. It’s been a bumpy ride over the last few months, but what we are seeing is a lot of cash moving out of equities, looking for fixed returns – bonds, real estate and so on.

We’ve seen specific niches of commercial real estate demand absolutely rocketing. A gauge of this is the compressing of capitalisation rates and buildings across many sectors. The two hottest ones that we picked up are industrials and medical office buildings. We’ve seen medical office buildings changing hands well below a 5% cap rate. That’s effectively your investors happy to take a 5% return on those investments over the course of the investment. That’s low. When we got into this business about eight years ago, we were looking at 7% and 8% cap rates. That’s a lot of inflation that’s happened on these medical office buildings.

Inflation is actually good for commercial real estate because, if you think about it, cost push makes it impossible for any new construction of competing space to come close to providing anything new at competitive lease terms.

Also, we can renew leases at CPI-plus rental rates that increase the income of the building, which is one of the major levers that increases the value of the building.

So inflation is not necessarily bad. I think obviously you’ve got to be concerned about the expenses, but just remember a lot of our leases are double or triple net. For those that don’t understand what that means, effectively many of these expenses or costs are passed through to the tenant. Our biggest variable cost is debt, and of course that’s what’s on everyone’s mind. But we always fix our debt on our buildings and, to give you an idea of what that sort of rate is, for fixed you pay more than you pay for variable. But on our new Boynton Beach building that we acquired in Florida, we are fixed at 3.5%. So, the arbitrage between 3.5% and 5% is a factor.

If we contain our costs and we ramp up our revenue – remember that commercial buildings are valued based on a factor of NRI, non-returning income, and capped – when we sell the building at the end of the investment period, we really are expecting stronger capital growth than we model in our projection. So that’s translating into higher returns for investors than we are actually projecting ourselves.

CIARAN RYAN: All right. So, you’re taking a fairly conservative view on your expected returns, but give us a sense of what the last year was like for OrbVest. Are you still able to find buildings that meet your investment criteria, and what are those criteria?

JUSTIN CLARKE: No, it has definitely got tougher. As I mentioned, the really good-quality buildings that are out on the market are trading at ridiculous prices. So it’s becoming more difficult to find quality medical office buildings that meet our investment criteria. I guess on the other side of it, eight years in the game and we are building a really solid reputation, especially after our quite aggressive year last year.

We are now getting offered buildings that are off-market, and the difference between off-market, where you can sit down with a seller and negotiate a price based on what makes sense, and something that’s out in the market being blasted all over America by the brokers, makes a significant difference.

That’s certainly working for us and it’s helping us to acquire buildings at about a 6% cap rate, which means that you’ve already got some upside when you acquire the building.

As our chairman says, you make money in commercial property when you buy the building. So yeah, returns on new acquisitions have dropped already and you’ll see if you look at our most popular product, which is our diversified holdings product, we are offering a cash-on-cash of 7%. Conservative, yes, but we’d prefer to be conservative and make sure that we can deliver that.

And ultimately our IRR [internal rate of return], I think we used to say 11% to 17% – we dropped that to between 10% and 17% because we think that that’s a little bit more realistic, considering where we are.

CIARAN RYAN: Okay. Medical real estate is generally perceived as a defensive investment in the sense that people will always require doctors and medical treatment. Is this reflected in your tenant profile? In other words, high occupancies, low tenant turnover?

JUSTIN CLARKE: Yes. This is a very interesting space to be getting into now, and I think this may be the subject of another interview. But generally doctors are very sticky tenants. They don’t move. Think about your doctor, your dentist. Generally you’ve been seeing the guy in the same building for most of your life, especially when located near a large hospital. Hospitals make them sticky because of all the services that aren’t offered within the hospital that they need to service.

The way medical services are delivered is also changing incredibly fast and plays a hundred percent into our model.

Remember that inpatients – the patients who are going into hospital for a procedure – are dropping off globally, including in South Africa, and outpatients are rocketing. The reason for this is obviously changing technology. You can go for a significant operation by having some microscopic surgery and even, to be quite honest, some major stuff. In the States, you’ll do a hip operation, and you won’t go to hospital. You’ll go into your medical office building and have your hip operation. It’s very interesting.

We also look for a very specific type of tenant. We like multi-tenant buildings that have a synergistic relationship between all the tenants. We really look for heavy medical that can’t be disrupted by any changes. Specifically, these are surgery centres where a proper theatre is put in. Imaging requires a Faraday Cage – thick concrete walls, lead protection and so on. And of course oncology, where the big oncology machines have a radioactive nature, the buildings literally have to be sitting in a bunker.

As for the cost of the equipment, some of these machines cost more than the actual value of the building, so for them the lease is a smaller part of their problem. If they’re going to put one of these machines in, then they are absolutely looking for a 10- or a 10-plus-year lease with options to renew.

We also limit exposure to primary healthcare. That’s general family physicians, unless they’re part of a larger group, because this is one of the changes that’s happening in this space.

CIARAN RYAN: Okay. So the focus of your investment is the US, as we’ve been talking about. But you originated out of South Africa as a company, and you have a large South African investor base. What sort of profile of investor are you looking to attract, and are they mostly South African?

JUSTIN CLARKE: Very interesting. When we started up, it was really looking after a few of a designer group, individual friends, and then ultimately, we opened that up to other investors. South Africa is still our largest investor base. I think this is probably driven by our own political and economic challenges. But it is changing, and changing fast. Then Covid came and slowed that down a bit. But we expect that this year equity from the US may well overtake SA as the largest source.

Interestingly, the country that’s come from nowhere is Israel. Israel is awash with cash, and Israelis are looking to invest in the US. So they look for these types of investments. But I think the big news, Ciaran – and I think we spoke a little bit about this offline – we are working to open up to the financial advisory space, and these are financial advisors who sit on all their clients’ money. There’s huge interest from them to place clients’ money in this type of alternative asset. They also have a need to manage their clients’ funds on proprietary platforms, the platforms where they would run and manage their own clients’ fund. And that has proved to be the challenge. Traditionally investors come directly to us. I guess they’re mostly middle-aged, more conservative, looking for security towards the middle and end of their lives, looking for income-based investments. The US dollar income is a major drawcard of course. But I think a fair majority of [our investors are] South Africans, to answer your question.

CIARAN RYAN: Final question, Justin. What can we expect from OrbVest in 2022? Are there any new products or projects in the pipeline we should know about?

JUSTIN CLARKE: Well, as I mentioned earlier, our diversified portfolio offering is starting to look like a small closed fund, but at the same time you know into what buildings your money will be deployed. In other words, it’s a limited group of buildings that are in there. This has proved to be very popular. The product that we have at the moment is ODH 5, and it’s the fifth version of it. The others are all fully subscribed.

The other one we launched last year is the Triple Net portfolio, and I think this is really going to go well. Remember triple net, as I explained earlier, is made up of a group of mostly single buildings. The best example I would use is to think of a CVS. CVS is a huge multinational credit tenant; they have thousands of these CVS outlets all over the place. You get a CVS lease, you are absolutely certain that your lease is going to get paid. You have a weighted average lease-term period of 10 years. That’s one of our criterion for our Triple Net portfolio.

Basically you’re buying an income stream for 10 years. We’ll hold it for five and then we’ll sell it off. The name ‘Triple Net’ means that you don’t actually have to worry about the maintenance and the expenses of the operating of the building. That is absorbed by the tenants. You do nothing. We buy the building and we collect the rent. We just collect and we distribute to the shareholders.

Those two are products we have already, but we’ve got some bigger things in the pipeline – I think maybe that’s a conversation for a future call. But as the teaser we’ve got a lot of money sitting in our trading accounts, in other words, [for] people who have moved the money but they haven’t decided on a building, the idea is to offer a 30-day fixed-income note, which is coming soon.

And then a little further out, because of the legalities involved, we are working on a fund out of Ireland. That’s also on the cards.

CIARAN RYAN: Okay. Exciting times ahead. We’re going to leave it there. That was Justin Clarke, chief operating officer at OrbVest.

For Moneyweb listeners, we will be hosting a webinar with OrbVest. We’ll post details of that webinar on moneyweb.co.za shortly.

Brought to you by OrbVest.

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