Discussing the possibilities and future of the intersection of healthcare and commercial real estate
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This week’s episode of the Providers, Properties and Performance podcast is an interview where Brent Lacey interviewed me on his The Scope of Practice podcast. Brent’s The Scope of Practice business aims to educate his fellow physicians on financial health and in this interview we discuss the economic benefits of physician ownership of the place where a clinician practices as well as physicians becoming real estate investors. Brent is also a practicing physician at Texas Digestive Disease Consultants.
[2:19] How I got into healthcare real estate
I started out wanting to get into commercial real estate, and of course there are various “flavors” of that. I wasn’t quite sure exactly what I wanted to do, and I worked for a developer of medical office buildings as I was finishing up my graduate degree. One of my projects was a marketing report for a new on-campus building that they were developing, and then I started to work in their leasing department. I felt like I had found my calling, because I really enjoyed working with physicians. Helping them find space to operate made me feel good.
Another aspect that drew me to healthcare real estate was that it is mission-critical and demand-driven. Physicians cannot do procedures out of their homes. We need emergency services, hospitals, and surgery centers. Even with the increase in tele-health options, we will always have to go to a physician for in-person exams. The .com boom was happening back when I started, and I saw that technology was becoming so prolific that it was likely that everyone wasn’t always going to have to come into an office to work. That isn’t going to happen with healthcare.
Physicians work all day long and they need help. They need accurate information quickly in order to make decisions, and they often don’t have the time or the desire to figure out real estate investment. Being a part of doing something good for these busy professionals, working in a fast-paced environment, and contributing to the greater good in the healthcare industry really worked well for my personality and it blossomed from there.
[6:15] The time it takes to be a physician owner while also practicing medicine
The million dollar question is how to own medical facilities while still practicing medicine. I once spoke to a hand surgeon, and he and his son are in a practice and looking to open a surgery center in a medical office. They want to buy a bigger building to also have an investment income.
When I ask physicians if they still want to practice medicine during the day while taking on a part-time job managing real estate, typically they do not. These doctors, for example, would make more money doing more surgeries than they would managing their real estate. So there are professional property managers that also specialize in healthcare properties. The specialization is important because they have to deal with hazardous waste and there are stringent cleanliness guidelines for medical facilities. If you have a surgery center, that is even a whole different level of cleaning that needs to be taken into account.
The property manager not only handles the vendors for janitorial services, but they also do property accounting. They collect the rents, send out late notices if needed, and manage the budget for them. The physicians don’t have to be involved in the day-to-day, but they can meet monthly or quarterly with their property manager. This keeps them out of the weeds of managing a piece of real estate with their already hectic schedules.
[9:47] The money involved with buying versus leasing healthcare real estate
The pros and cons of buying versus leasing depend on the specialty. If it’s more community medicine like family practice, internal medicine, OBGYN, pediatrics, they can typically find a second-generation space. Something will be about 90% there and then they can make it their own with paint and carpeting.
When you get into specialties that require procedure rooms or imaging, it may become more expensive. You have to start analyzing the amount of tenant improvements that the practice would have to spend inside the building. For plastic surgeons, or the hand surgeons I mentioned earlier that wanted two ORs and a procedure room, that is an expensive buildout. Taking the common sense approach, you think about dumping $150 to $185 per square foot into a building I don’t own, and after 10 years I probably have to sign up for more time on that lease, it doesn’t make much sense. If you bought a building, even if it’s an adaptive reuse where you’re just being a shell, and built it out over the same 10 years, that makes more sense. You build equity, and you could always grow into a bigger practice or get bought out by a hospital. Having your own building makes these things easier. So, if your costs for tenant improvements is high enough, buying gives you more flexibility than does leasing. It also may provide more stability and a better use of your investment dollars to own your property.
[13:42] The capital side of healthcare real estate investment
If you’re a single practitioner or if you have a practice of a handful of physicians, SBA is a great tool to get started and they have programs specifically for physicians and healthcare companies. If you are bigger than that, a several million dollar company, and you have some track record, there are a whole host of private real estate investors that specialize in joint ventures and bringing capital to a development. So, if you are in a practice with some financial strength, they will partner with you so you don’t actually have to outlay the capital. They do want a commitment, and it will involve shared capital investment, a lease, or something like that. Joint venture capital allows you to still have some control and ownership in the building, but you partner with these capital providers and experienced developers that can really help you.
I think physicians often wrestle with the idea of taking on more debt. They are typically already in debt, and then they have to take on more if they want to invest in property. I think that creates analysis paralysis, and it prevents them from expanding. If they have an expansion plan, however, there is always a way to get it done. They can find a capital partner to work with them, or they can work with somebody like myself that understands the personality of a practice and knows the partners that might make the most sense for them to talk with.
[15:55] Choosing to buy an existing space or build your own space
When you are looking at a building, there is the cost of the shell and then the cost of the tenant improvements. Along with the cost of the shell, there are the hard costs of constructing it along with the soft costs of architectural fees. You also need people to manage the project, bringing additional fees as well. So if you can buy a building with a shell already intact, even if you gut the entire inside, it is typically cheaper than building from scratch.
You also have to take into consideration the supply of available buildings or land in relation to where you want to be. Doing adaptive reuse of retail spaces has taken off in healthcare real estate, because retail typically has the parking and the visibility that a lot of practices and healthcare companies are going for. A lot of hospitals have these urgent care centers, and they want them on the street corners just like CVS or Walgreens. Patients have easy access and they are easy to find.
When you consider all your costs, buying is typically less expensive than building. It depends on the markets, and if the prices of the buildings become too high then it will make more sense to build from scratch. If the prices of existing buildings are low based on market conditions, then it is cheaper to buy an existing building and build it out from there. A lot of it has to do with location, market conditions, and the associated costs of either option.
[18:55] How to pick the right location for your healthcare real estate
The first important thing to look at is data around where your patients are coming from. You may have to find a balance between where they are coming from and where you as the physician want to commute to. For example, I have had some conversations with physicians that have a lot of worker’s comp patients. They need to practice in more of a blue collar area, but they might live somewhere else. It’s a happy medium where they can have a geographic target zone in order to make it easier for their patients to get to them without giving themselves too long of a drive on a daily basis.
Once you find some target areas to consider, there may be other factors like needing to be a certain distance from the hospital. Typically with outpatient care, however, my biggest tip is to find out where your patients are and see how you can make it easy for them to get to you.
[21:52] Factors to consider on a five, ten, and twenty year timeline
If you are in a lease that you have three years or less on, I would say you want to start thinking now about what you want to do. You want to give yourself enough runway to make these decisions, because it will cost you less in the long-term as well. With more time to do due diligence, interview vendors, and consider different options, you will make the best decision.
I used to do a lot of leasing and physicians would come in saying they got a 30 day notice from their landlord and needed to find a place. Getting a lease and doing a buildout is at least a 6-8 month process. You have to find the place, negotiate the lease, and do the buildout including getting any needed permits. If you are considering buying, you also need a lot of runway to find a deal, negotiate a deal, and do it all without being pressured into something.
The worst thing in real estate is to be in a position of negotiating without any other options. You just never know how it’s going to go. After an inspection, you might decide there is too much that you don’t want to repair. You don’t want to be forced to make a decision on the only option in front of you. I like to have options for my clients to consider. There can be an adaptive reuse option, a piece of land you could buy and build on, and then a third option for them to really analyze the costs associated with it and how it will fit into their long-term plan.
When you are getting toward three years or less on your lease, that is when I would start thinking about your long-term plan. If you are in a building and you are looking to get another building, I suggest giving yourself a three-year buffer before you start telling your patients that you are going to have another building closer to where they live. Give yourself the time to find the right place and to have some options to consider.
[24:37] The upside to being a physician owner
There is something to be said for the fact that physician owners can design and build things out as they want to a certain extent, but there is financial upside as well. It does depend on how you buy it, but typically you can see internal rate of returns at around 16%. There is a range, and it is usually anywhere from 8% to 23%, but a good IRR is around 15-16%. There is also a ton of upside to having equity, and you can continue to recapitalize it, refinance, and pay down your loan. When you are done practicing, you will likely have a network or maybe you will have hired younger physicians who can play a role in your succession plan. If you have an internal succession plan, you can get out of the operational part of the business but still own the real estate for some cash flow. You could also likely find another medical group to take over the building, either selling the building with the lease to an investor or you can keep it as an investor. Being a physician owner gives you a lot of options for future cash flow and return on investment.
[26:26] Taking advantage of a high internal rate of return
The first thing you need to do is keep the property in good condition. You don’t want to neglect it, and then have 20 years of deferred maintenance that ends up being incredibly expensive. You will have to either pay for it or discount the price when you’re trying to sell it to an investor. The lease needs to be market rate, which is standard with Stark Laws, but you also need to have a very well-managed building. The operating expenses can kill you. You need to maintain HVAC, electric, and other utilities, and also make sure your property taxes are paid.
Every year or every couple of years you should do a review of your vendor costs and make sure that they are still competitive. If they aren’t performing well, you would also need to make a change. Managing your building from an expenses standpoint is huge, because the lower the expenses, the higher the value. There is a balance between making sure that it’s well-maintained but that you aren’t overspending when it comes to expenses.
[28:51] The timing of healthcare real estate investment
Investors often want 12-15 years of a lease term, but you really need more like 10 and sometimes even 5. For the ones that know what they’re doing and will likely be a better match over the long term, consider your next 10 years. Say you have several buildings and you have different partners that own different pieces of each building. It might be easier to do a sale leaseback now in order to get the equity out. You would put them up for sale with 10 year leases on them, and investors will buy them if they are in good physician condition and your practice is financially healthy. That is when you can compress the cap rates and get top dollar because you are selling it with the lease in place. You may also want to consider this if your practice needs to expand, but for whatever reason you don’t want to use other capital resources. It is almost a way to self-fund expansion, because you can get the equity out of your building. A sale leaseback is the best way to get a lot of your equity.
A lot of practices get to the end of the 10 years and don’t want to deal with finding another tenant or managing the building. They want to be done and move on. They can go through a similar process and sell to investors, or they may want to sell because they are getting bought by a hospital. It is a win-win when an investor gets hospital grade tenants, and at the end of the day the doctors just want to be employed physicians and to be done with real estate.
[32:32] Structuring legal ownership of real estate
I am not an attorney or an accountant, and I do recommend that your real estate decision is aligned with the advice of those two professionals.
Typically, I see that the real estate is owned in an LLC regardless of if it is the same physicians that practice in the operation or not. The rent is collected and the expenses are paid through the LLC. Having a separate LLC allows for separate functions and you could make decisions on the real estate that are independent from the practice itself.
If you have a large practice with 20 partners, it might be tough to get a consensus for a real estate decision and not everybody might want to be a part of the real estate either. Having a separate LLC offers the flexibility for the people who want to invest to be able to do so. The units could be divided equally or by seniority, but structuring it this way allows for different options.
[34:48] Working with a healthcare real estate advisor
I would first ask if they have ever done a medical deal before. It can get commoditized where people think that someone they know with a residential real estate license can transact commercial deals well. There are a lot of differences in the markets, and people who are in the healthcare real estate space may have access to different information. For example, I get calls about practices that are available but won’t go on the open market.
You also want to work with someone knowledgeable about the market. If they aren’t in tune with the market conditions of medical offices, you could get into a stressful situation. There are a lot of properties that may be marketed as office and medical that really aren’t medical at all. Medical groups may go in there, but they are probably paying a lot of their own tenant improvements out of pocket. If it is a true medical office building, you will have to pay higher rent but you won’t have to work with a building where the owner has only underwritten carpet, paint, or $10 to $15 in tenant improvements.
As a healthcare company and medical practice, you’re not necessarily wanting to use all of your operating capital on building out your space. You actually want it for your business. It is a different animal, and there are investors, landlords, architects, and a whole host of professionals that do focus on medical office. If there isn’t one in your market, you can get an architect under contract. There is a network of contractors that specialize in medical office that could give you a good referral. So, there are different ways to make it happen so that you have the proper advisors. At the end of the day, the mistakes will cost you.
Especially when doing a sale leaseback, you want to make sure the buyer understands that you are a healthcare practice. There are nuances to that, and you want to partner with people who are going to put you in the best possible situation.
Links to resources:
The Scope of Practice Podcast
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