SE Medical Office Portfolio, DST

Memphis, Tennessee / Southaven, Mississippi

ASSET CLASS:  Medical Office Portfolio
OFFERING SIZE:  $10,008,000
LEVERAGE:  43.16%
SQUARE FEET:  29,906
YEAR BUILT:  1991 (renovated in 2010) / 2005
HOLD PERIOD:  7-10 Years

Both buildings feature 15-year, absolute net leases with four, five-year renewal options and 2% annual rental increases. Properties are located near the campuses of Memphis’ top two ranked hospital systems. The tenant, OrthoSouth, was formed by the merger and rebranding of three orthopedic practices: Memphis Orthopaedic Group, OrthoMemphis and Tabor Orthopedics.

The principal investment objectives will be to (i) preserve the Investors’ capital investment, (ii) realize income through the operation and, within approximately seven to 10 years, the future sale of the Projects, and (iii) make monthly distributions to the Investors from the Rent collected under the Master Lease, which will be passive income and may be partially sheltered as a result of depreciation and amortization expenses.

OroSouth is adjacent to the campus of St. Francis Hospital-Memphis which has 479 beds. The Southhaven building is located next to Baptist Memorial Hospital-DeSoto that has 339 beds.

The Projects are NNN leased, thus, applicable capitalization rates are found within the net- leased medical office sector. According to the December 2019 Medical Office Research Report produced by CB Richard Ellis (the most recent report as of the date of this opinion), conditions within the medical office market are strong. Over the past two decades the healthcare industry has shifted away from on-campus treatment to favor outpatient care in convenient locations. The demographic and health-care industry trends are now firmly entrenched and forecast to persist, supporting long-term demand for medical office space. According to CBRE, the U.S. medical office vacancy rate remained at 10.3% through December 2019 and average asking rents stayed near record levels. Rent growth fell to 1.8% (increasing at a slowing pace) year-over-year, down from the five-year average of 2.6%.

Completions of new medical office space surged in 2019. However, the current pipeline of new medical office construction has declined by 29% since the peak in 2016, which should help provide stable market conditions in the near term. While the recent spike in supply possibly weakened the future rent growth trajectory, a low vacancy rate should help provide stability.

Pricing for medical office buildings remains strong. Growing demand from top-tier institutional investors, foreign investors and REITS is fueling investment demand and strong pricing. Medical office cap rates are at record lows. As of December 2019, CBRE indicated the average medical office cap rate was 6.6%, below the average conventional office cap rate.

According to the third quarter 2019 Net-Leased Medical Report completed by The Boulder Group, cap rates for the single tenant NNN leased medical product were down two basis points over the level found one year ago. The third quarter 2019 medical cap rate was 6.45%, while the cap rate found during the third quarter of 2018 was 6.47%. The Boulder Group also indicated single-tenant NNN medical properties were in high demand. The medical sector is still one that consumers and service providers typically meet in a face-to-face setting and many investors have shifted their acquisition focus to e-commerce resistant product. Additionally, single-tenant medical leases typically possess strong rental escalations throughout the term, providing investors with an inflationary hedge.

Medical net-lease cap rates remain at a discount to the overall net lease market. In the third- quarter of 2019, net-lease medical properties were priced 10 basis points below the overall net- lease market.

The single-tenant net-lease medical sector will remain active as investors remain attracted to the long-term outlook for healthcare related properties. The sector’s resistance to e-commerce and the country’s aging demographic will keep investor demand high.

While we acknowledge the above data for the net lease medical market is somewhat dated, much of the data available as of the date of this opinion does not accurately reflect the true impact of the COVID-19 pandemic on the market. The fallout from the COVID-19 pandemic started in mid-March and the 10-year treasury fell to as low as 0.39% as the Federal Reserve slashed rates in an effort to mitigate market uncertainty. Most publicly traded net lease institutions saw significant reductions in their valuations, giving rise to investor concern over their financial health. In addition, the subsequent shuttering of the U.S. economy has led to significant financial stress for many publicly traded and private companies. As a result, overall net lease activity for 2020 is expected to be down significantly. Early indications, however, regarding capitalization rates, indicate cap rates holding relatively steady in all categories. Furthermore, the stabilization of the 10-year U.S. Treasury yield in the second quarter will provide investors with an enticing yield spread.

MSK Group, P.C. d/b/a OrthoSouth, offers world-class orthopedic care across eight clinic locations and two surgery centers across the mid-southern United States (Tennessee/Arkansas/Mississippi). The practice provides surgical and non-surgical treatment in general orthopedics and subspecialty areas of sports medicine, shoulder, back & neck, spine, hand, foot & ankle, hip, knee, arthritic total joint replacement, treatments of bone and soft tumors of the extremities (benign and malignant) in children and adults, worker’s compensation injuries, and physical therapy.

In 2019, three physician owned orthopedic groups based in Memphis, Tennessee (Memphis Orthopaedic Group, OrthoMemphis, and Tabor Orthopedics) joined together to form OrthoSouth. The practice employs 35 physicians and 44 physical therapists.

According to internally-prepared financials provided to our firm, MSK Group, P.C., had revenues for the fiscal year 2018 of $66.2 million with $13.2 million in discretionary bonuses paid to the physicians and a net loss of $1.5 million Financials for 2019 indicate total revenue of $72.9 million, a 10% increase over 2018, with $14.7 million in discretionary bonuses and a net loss of $42,042. We note that OrthoSouth distributes excess cash flows as discretionary payments to the physician owners that manage the practice for minimal tax liability. Results for the trailing 12- month (“TTM”) period ending May 2020 indicate revenue of $73.4 million and net income of $1.3 million. As of April 30, 2020, MSK Group, P.C. had total assets of $15.9 million, total liabilities of $16.6 million and total equity of -$656K, a position which has been improving steadily over the past three years.

Discussions with the Sponsor have indicated MSK Group, P.C. has fared well through the COVID crisis. The company applied for and received PPP proceeds early and has been able to avoid laying off or furloughing any of their employees. Restrictions for clinic visits and elective procedures were lifted May 2, 2020 and facilities were operating at 100% year-over-year volume by May 25, 2020. Backlogged cases will drive steady volume through fall and has established procedures for telehealth procedures are in place to serve customers.

Targeted Yr.-1 Cash-on-Cash: 5.80%
Targeted Cash Range: 5.20% - 6.25%
Targeted Cash Average: 5.71%
Targeted Cash Range w/ Principal Paydown: 5.80% - 8.81%
Targeted Cash Average w/ Principal Paydown: 7.36%
Projected IRR (based on a sale at purchase cap rate): 6.83%

All-In Price: $17,608,000
Purchase Price: $15,013,000
Appraised Value: $15,950,000
Loan Amount: $7,200,000
Equity Raise: $10,008,000
Accountable Reserves: $559,972
Reserves to All-In Price: 3.99%
Reserves to Equity: 7.01%
Net Load: $2,035,028
Net Load to Equity: 20.33%
Net Load to All-In Ratio: 11.56%
Appraised Net Load: $1,098,028
Appraised Net Load to Equity: 10.97%
Appraised Net Load to All-In Price: 6.24%

Net Operating Income: $962,165
Purchase Cap Rate: 6.41%
All-In Cap Rate: 5.46%
Breakeven Exit Cap: 6.98%
Breakeven Exit Cap Rate Spread: 57 bps
Appraised Cap: 6.03%
Appraised Cap Rate Spread: 95 bps

Loan Amount: $7,200,000
Term: 10 Years Fixed
Interest Only Period: 2 Years
Amortization Period: 30 Years
Interest Rate: 4.15%
Lender: Citi Real Estate Funding
LTV: 43.16%
Non-Recourse: Yes to Investor

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