Occupation cost is among the greatest expenses of any medical practice. Thus, the decision to buy or to lease medical real estate is among the most important any practice will make. However before making the decision to buy or lease, one must understand real estate market dynamics and the objectives and career timelines of practice partners. Among the most critical considerations are local market conditions, individual risk tolerance, likely length of stay in a given location, the possibility of future growth and the stability of a practice. Here, we look at the advantages of buying and leasing in the context of those considerations and others.
Buying – The Advantages
Real estate has historically been one of the greatest sources of wealth. Today, over one third of the world’s richest people created their wealth by investing in commercial real estate. Most importantly, real estate builds wealth more consistently than any other asset class, without the kind of recent, unimaginable volatility in the stock markets.
“Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.”
– Franklin D. Roosevelt
Ownership offers more controlled occupation costs, creating greater financial certainty. The ownership can decide when and how various maintenance and capital improvement issues are addressed, presenting the best public image while controlling costs. Further, the ownership controls its environment from temperature settings to interior finishes. If the building has other tenants, the ownership can choose those tenants that are most complimentary to its practice.
A typical commercial mortgage is amortized over 20 years, so practices with partners who have 10 to 15 more years of active practice ahead of them are best positioned to purchase. Toward the end of that timeline, mortgages have been substantially paid down or paid off and in most cases, the property has greatly increased in value. The practice now owns a large share of equity in the office building. Meanwhile, leasing costs have risen most years and the practice has no equity to show for a lease.
Leverage is another word for borrowing or debt. Using debt allows you to make more with your money. With leverage, you can control a large amount of property with a small amount of your own money. Let’s assume you put 10% down to buy a $1 million property, and you receive a bank loan for the other 90%. If the property appreciates by 10% and is now worth $1.1 million, you’ve made a 100% profit. Your $100,000 investment turned into $200,000, so you doubled your money.
Ownership of Improvements
You have the creative freedom to make any changes you want to the property. This allows for easier improvement projects, as they have no limitations. Any enhancement of the building or space will directly improvement benefits for you, and not your landlord.
Flexibility for Growth
Buying more office space than the practice needs initially, creates the possibility of rental income and the flexibility of growing into that space as the practice expands.
Real Estate has never has never been worth zero.
Compelled Retirement Funding
Most retirement contributions are voluntary. No one misses his practice real estate mortgage payment. Years later, leasing the space to younger physicians or a new practice can produce a steady income stream upon retirement. Or the owner can choose to sell and distribute or invest the proceeds, sometimes tax-free. The owners can also sell the building and lease it back to the existing practice to cash out their equity and facilitate a more comfortable retirement.
Ownership can improve recruiting when a practice structures ownership in a way that makes it easy for partners, upon retirement, to convey their ownership interests to younger doctors joining the practice. Younger doctors will express more interest in joining the practice, ultimately bringing more freedom to the real estate ownership.
Buying – The Disadvantages
Ownership isn’t without risks or responsibilities. Among them are:
Upfront Capital Requirements
When buying a Medical Office Building (MOB), 100% financing is sometimes available for established practices. However, lenders often require 10% to 20% down for owner/occupied medical real estate. In addition to the cost of the building, changes and improvements to the existing space can cost from $75 to $100 per square foot or more. With a 10,000 SF MOB selling for $2 million and requiring $75 per square foot in improvements, a 10% down payment would be $275,000. That’s before fixtures, furnishings and equipment.
It has been said: “Buildings never move, but neighborhoods change all the time.” Demographic changes often affect the quality and desirability of a given market area and negatively impact property values therein. Once vibrant areas can lose vitality due to new Interstate development, the loss of a significant employer or several other factors.
Ownership must be prepared to continually reinvest in its MOB space to keep it attractive and relevant to patients.
Real Estate Market Reversals
The current business upcycle is unprecedented in its length and strength, but these cycles see peaks and valleys. Economic downturns affect property values. When this happens, a practice owning a MOB with tenants may see lease rates fall, lowering net income and distributions to the partners. Selling with property values falling may require some time.
Property management is a significant undertaking, and in virtually every case is best handled by a professional management company, especially with multiple tenants. Partnership documents must be carefully drafted by an attorney with significant real estate and medical practice experience to create a clear structure for property management decision making. This will minimize the possibility of conflict.
“One day, the elevator went out completely. That was bad. There was only one elevator in the building. How are my elderly patients going to get to the third floor?” a doctor asked. “They aren’t,” I replied. And they didn’t.’
Martin Amisformer MOB landlord and property manager, as quoted in the Wall Street Journal.
Leasing – The Advantages
Leasing offers many advantages. Among them are:
Lower Initial Costs
Leasing costs can be significantly lower in the early years, though that may change over time as lease rates increase. A CPA with significant healthcare and real estate experience should be engaged to project total costs over time for buying and leasing, considering tax implications specific to the ownership. The practice must, understands its breakeven point.
In many cities, the best, most well-located MOBs are not often for sale. Leasing a highly desirable location that isn’t available for sale could pay for itself in added revenue.
Since commercial real estate is an illiquid investment, there’s less flexibility when compared to leasing. Lease terms can be as short as three years, while commercial mortgages can last for 20-25 years. Ownership can make it harder to move to a new location if the neighborhood declines. If the practice could be a target for acquisition, a poorly structured ownership document could complicate a purchase and discourage buyers.
When you lease commercial real estate, upfront expenses are a fraction of those required for ownership. Your practice then has more cash to be used for marketing, training and/or the purchase of expensive medical equipment since less capital is tied up in a long-term asset.
Like buying commercial real estate, there are many tax benefits associated with leasing. Specifically, the types of costs that you can deduct from taxable income include lease payments, and pro-rata property taxes, property insurance, utilities, and maintenance required under a “Triple Net” lease. Unlike buying commercial real estate, it’s possible to deduct the entire amount of your lease payment. In some cases, you may realize more tax savings when you lease.
“Next to being shot at and missed, nothing is quite as satisfying as an income tax refund.”
–F.J. Raymond, Novelist
Leasing – The Disadvantages
No Investment Benefit
Since you don’t own your commercial space, you won’t be able to take advantage of long-term increases in value. That means that you can’t earn a return in the form of price appreciation in the event of a sale or refinancing. Since you can’t act as a landlord, there’s no rental income potential. The absence of any Return On Investment (ROI) increases the comparative costs of leasing vs. buying commercial real estate.
Higher Monthly Payments
Depending on lease terms, your monthly rent could be higher than a monthly loan payment for a similar space. For example, “Triple Net” leases are increasingly common among MOB landlords. These leases make tenants responsible for their pro-rata share of such landlord’s costs as property taxes, insurance, common area utilities and maintenance, adding up to $9.00 per square foot to tenant’s base rent. Those expenses, coupled with base rent will often cause the monthly lease to be more expensive, on average, than a monthly loan payment.
Less Property Control
As a tenant, you’ll often be at the whim of your landlord. There may be restrictions on the type of improvements you can make to your space. Your landlord may charge extra for electricity consumed on weekends or late evenings used to heat or cool your space. And while lease agreements usually outline annual escalations in rent, once your lease ends, and you have no optional term left, your landlord can increase rent above and beyond the escalations outlined in your previous agreement.
Contact Chris Zarpas For More Information
Cost and location are the most important considerations when determining whether to buy or lease. Expert analyses have shown that for those practices likely to stay in the same location for more than seven years, buying offers lower costs by comparison to leasing.
When choosing a location and deciding whether to buy or lease, seek the input of a commercial real estate broker. As brokers with a primary concentration in medical real estate, we offer our clients and their financial and legal counselors’ current, in-depth market knowledge and demonstrated experience in healthcare real estate acquisitions, dispositions and leasing representing buyers and sellers, landlords and tenants. The savings we offer in time and money will allow you focus on your primary objective – delivering the highest quality healthcare possible with the lowest possible expense.
Chris Zarpas is Vice President at SL Nusbaum Realty Co. Founded in 1906, S.L. Nusbaum one of the largest real estate development companies in the southeastern United States. S.L. Nusbaum Realty Co. offers the full spectrum of real estate services, including mixed-use development, commercial development, multi-family development, property management, leasing, sales & brokerage, and full menu of financial service. SL Nusbaum Vice President. Contact Chris today at (757) 640-5437 or contact us online for more information.