Hospital Campus MOBs Need Special Handling

NEW YORK CITY-Medical office buildings have been a well-performing sector, and are poised for more growth through development due to demographics, the Affordable Care Act and other market factors. Many MOBs have been and will continue to be located on hospital campuses (or otherwise affiliated with hospitals) due, in part, to continuing consolidation of smaller doctor practices into larger groups, often owned by hospitals. The involvement of the hospital differentiates a campus MOB transaction from the unaffiliated MOB transaction or ordinary commercial real estate transaction.

Typically, the hospital will be the landlord under a ground lease or, in the event of the acquisition of a fee interest by the MOB owner, the beneficiary under restrictive covenants of record (recorded documents). The hospital may also be an anchor tenant in the MOB including potentially operating an ambulatory surgery center therein. A new MOB development will involve a comprehensive negotiation from the start with the hospital, whereas the acquisition of an existing MOB will require the evaluation of the hospital's rights under an existing ground lease or Recorded Documents, and may require fresh negotiation of certain issues with the hospital.

When entering into MOB transactions, hospitals are faced with the conflicting interests of providing its doctors with offices close to the hospital, and preventing competition with the hospital. Hospitals will attempt to restrict uses in the MOB that compete with services (then or in the future) provided by the hospital (other than for space leased by the hospital itself (or its affiliates) in the MOB). For example, hospitals with pharmacies may prohibit or restrict the location of pharmacies. In addition, the ground lease will often limit doctor tenants from performing diagnostic services (such as MRI services), unless such services are ancillary to such tenant's practice. The MOB owner must ensure that such are not so restrictive as to prohibit those ancillary services that doctor tenants would expect to be able to perform. The more overreaching the restrictions, the more difficult it will likely be for the MOB owner to lease up the MOB.

Further, especially with respect to religiously-affiliated hospitals, uses will be restricted that would violate the hospital's operating mandate. Finally, the MOB owner likely will be restricted from leasing to doctors not affiliated with the hospital (although, especially during initial lease up, and in the future, the hospitals may agree that if the leasing occupancy remains below a certain threshold for a certain period, the MOB owner can lease a portion of the MOB to unaffiliated doctors, and in turn give the hospital a right of first refusal or similar right so that the hospital can either allow the third party leasing or lease the space themselves under the same terms). Thus, MOB space leases must include covenants to protect the MOB owner from violating such restrictions, and provisions addressing a tenant's loss of hospital affiliation. Further, in many cases, if a doctor tenant violates a use restriction, the MOB owner will not be in default under the ground lease as long as it takes affirmative steps to enforce its rights and remedies under the space lease against the doctor tenant.

So the hospital can retain control over the use and ownership of an MOB, the ground leases often provide the hospital with rights to purchase the MOB. It is important that the MOB owner negotiate provisions for a purchase price based upon a fair market value determination (at the time the purchase option is exercised), and MOB owners will often seek to establish a “floor” for such valuation. The amount should never be less than the outstanding debt and prepayment penalties or premiums to ensure the ground lease is financeable.

Additionally, ground leases or recorded documents will typically contain a right of first offer or refusal in for the hospital with respect to a sale of the property or a controlling interest in the MOB owner, as well as restrictions on the sale of the property or interests in the MOB owner to other hospitals or healthcare providers. In turn, MOB owners typically desire that ground leases contain provisions setting forth the circumstances under which use and transfer restrictions (and any hospital purchase option and/or right of first offer or refusal) become inapplicable. For example, such provisions may be rendered inapplicable were the hospital to cease or reduce operation, or were the nature of the hospital to change.

Finally, MOB owners should confirm that the recorded documents provide for adequate rights with respect to the compliance with law and operation of the MOB, including with respect to ingress, egress, parking and utilities, and to be knowledgeable of the requirements of federal statutes related to healthcare as they relate to the ownership, operation and space leasing of MOBs.

This article highlights just a few of the material issues that are particular to an MOB transaction. When developing or acquiring an MOB on a hospital campus, one should discuss these and other issues with an experienced counsel at the outset of the potential transaction.

(This column originally appeared in shorter form in Real Estate Forum.)

Andrew M. Chonoles is the managing partner of Kleinberg, Kaplan, Wolff & Cohen, PC and a member of the firm's real estate department. Ross Yustein is chair of the real estate department, and Jason Polevoy is a partner in the department. The views expressed in this column are the author's own.