Discussing the possibilities and future of the intersection of healthcare and commercial real estate
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Today’s episode of the Providers, Properties and Performance podcast is my interview on the Grow Money Business podcast with host Grant Bledsoe (my guest on Episode 90). Grant is a certified financial planner helping business owners with wealth building strategies. Many of his clients are physicians, and we discuss the economic benefits of physicians owning the real estate where they operate their practice.
[3:46] My business and background
I am the managing principal at Doc Properties, and I handle commercial real estate for healthcare properties. I have been in this industry for about 20 years. I started on the leasing side and then moved over to the sales side.
I have worked with a lot of physicians in different stages of their careers. For those that are earlier in their career or that have been a single practitioner, they tend to be more geared toward leasing. When they want to grow, they then can expand into multiple sites. They may have paid for tenant improvements in their first leased space – whatever the landlord wouldn’t contribute – and so they have put in a ton of money into two spaces that they don’t own. They can’t take tenant improvements with them, except for certain equipment.
The office condo was pretty popular here in Arizona, where a developer would buy some land and then build office condos. They would do about 10,000 square foot buildings and then either divide them in quarters or in halves. With this model, smaller practices or single practitioners could still own and build out their spaces. At the end of the day, they are building equity. The issue with the condos is that sometimes practices grow, and it’s hard to expand adjacent to you when you don’t know the owner or if the owner is a completely separate business.
Now, I’m seeing where some entrepreneurial physicians are looking at leveraging time and money into real estate – which is something they often don’t fully understand. They don’t have time to take on a second degree or a part-time job to figure it all out. Physicians are typically high earners, and therefore they are looking to figure out how to invest in themselves. They want to purchase a property and invest in improvements that they can keep whenever their term is up. They don’t have to find a new lease and build everything out again. They may have to upgrade some things as they own the property, or sometimes they purchase a bigger property than they need to bring in additional income. It offers a lot of options for them, and at the end of their practice they can keep the building at lease it. Sometimes they will sell their practice to another physician, and then they can stay there and pay them rent. There are a lot of opportunities in physician ownership.
[7:42] Tenant improvements and out-of-pocket costs
It’s hard to transfer tenant improvements, as you can’t bring the walls with you. You might be able to transfer some equipment, furniture, or fixtures, but often you are starting from scratch. When physicians lease, however, they have to build their space out each time and they don’t own the tenant improvements. They aren’t making money on the value of the building at that point, and they have to start from scratch when they lease a new space. Buying a building allows physicians to put in tenant improvements that they can keep, more or less.
When you lease a space, your out-of-pocket costs include construction costs, architectural fees, and the FF&E. You will have the same costs in a new space that you own, but at the end of five, seven, or ten years, you don’t have to move and you own those tenant improvements. There is also some depreciation that you’ll be able to realize that you can’t do when you lease a space. There are a lot of benefits to owning long-term, rather than leaving.
[9:55] What to think about when getting into physician ownership
The first thing to think about would be the patient base. I would advise considering what patient base you are trying to attract, which private insurance(s) you accept, and whether you are worker’s comp based or accept Medicare or Medicaid. If a practice is leasing somewhere and the practice is thriving, they will not want to move very far from that location – unless they are looking to dramatically change their patient base.
Today, I think being conveniently located near your patients (when you’re an outpatient facility) is what I’m hearing is the goal for a lot of physicians. This is why they open multiple sites, because there is a certain drive time that becomes uncomfortable for patients. They will often open up another site to capture a patient base once the drive becomes too long. So for healthcare practices, it really starts with the patients you want to attract.
[11:21] Physician ownership as a wealth-building tool
Grant points out that a lot of businesses in other industries will seek to buy buildings that they will occupy around 51% of. When they do that, they have access to great financing because their business is occupying at least half of the building. It allows the business owner to leverage a bit more and buy a larger space, and they can then lease out the other portion to other businesses.
I sometimes see this with medical practices, but it depends on the supply of real estate. If they are building from scratch they might occupy 12,000 square feet of the site but find out the land can be built up to 20,000 square feet. Being a real estate person I would advise them to build it out to 20,000 square feet. They can occupy 12,000 square feet and hire a leasing broker to fill the rest. The market terms of the landlord would dictate what they would have to supply for tenant improvements, and they would get the SBA loan with the reserves to pay for the construction, offer tenant improvements, and pay brokerage fees and all of the other costs.
I would also recommend that physicians lease out their space to a complementary tenant, where there is some sort of logical referral pattern. The practices can then refer business to one another, and it is convenient for the patients as well. Some practices don’t want more building, and I think that is partly because they don’t know who will manage it. They don’t necessarily want to be a landlord and have to worry about collecting rent.
Along those lines, I strongly encourage practicing physicians who are working long hours to hire a property manager. They are well worth their weight in gold. You have to budget for the expense, but they can do so much while the physicians are working. They can manage vendors, collect rent, and do accounting for the property without having to burden the office manager who is already managing appointment scheduling, billing, and other tasks related to the practice.
Many professional property managers also have relationships with vendors that can save physicians money, and there are also service providers that specifically work on medical buildings. They understand the hazardous waste involved in a medical practice, and they know the janitorial service has to be exceptional. These professionals have a strong sense of what a medical property needs and they are able to provide that.
[16:53] Commercial property asset prices
With a house, I think you could look at five years. With commercial real estate, however, you really need to look at a ten year minimum time horizon. As an owner user, there are some upfront costs that take time to recoup. Across the medical office assets, the prices are really high right now. The cap rates are incredibly compressed. There is a lot of money chasing them, because there is a lot of hype behind them right now as being recession resilient properties. Some people are also concerned, I think, with the “Amazon effect” that the retail asset class went through. They are pivoting from that, and then the office building sector will likely continue to pivot due to the pandemic. Everyone is looking for a strong asset class, and right now the healthcare real estate market is incredibly strong.
Medical offices typically have long-term leases that are a minimum of five years. The tenant improvements have to be amortized over the lease term, and it’s not economically sensible to do that on a short-term lease. If they are shell spaces, leases are often seven or ten years, and even if a physician owns a building they have to be able to justify market rent. When you purchase the building and build it out, you need to keep costs at the point where, if you had to leave the property and lease it out to somebody else, you could still make your mortgage payment to your lender.
Right now, a lot of the increase in price is due to material and labor shortages. Demand is high and supply is low, so that is driving price increases. In popular places, land prices are increasing as well. All of these increased costs have to be underwritten with a certain ability to recoup the costs. So, the real estate fundamentals still have to be true with investment properties. The demand is high in medical office real estate, there is a lot of money chasing it, and prices are going up.
[21:04] Parameters we need to keep in mind when filling out lease terms
You can hire an appraiser, but I would also recommend that you get a broker’s opinion of value. Brokers are the ones who do deals all day long, so they know where things are actually striking and about the terms. There are two things you have to keep in mind. First, you have to get a lender to give you money. This is based on underwriting fundamentals. They will look at what the business pays you per week (based on current conditions). In addition, they will look at how much money you are asking them for the build-out. You could also ask for coverage of architectural fees. Lenders want you to have a budget and they want all the costs documented, because their team underwrites based on market conditions.
Sale leasebacks are pretty popular as well. Sometimes a physician will get purchased by a hospital or maybe another group, and they take over the lease. If the physician owns the building and it’s being leased to a hospital, they can sell that to an investor. The hospital is not going to take an adjustment above market, but they will look at your lease rates and either write them down to market conditions or require a new lease. When you sell it, investors will also analyze the lease rate. If it’s not market conditions, they will write it down to market conditions and then cap the income off of that. If you inflated the rate, you will have to accept a lesser price and they will probably make you sign a new lease based on market conditions. Everything needs to be based on the current market real estate fundamentals, just to keep yourself in line with all the other financial markets.
[27:10] Considerations when thinking about building versus buying property
Grant inquired about getting a construction loan and building your own building, especially in places where demand is high and supply is low. It would be a great route to go if there were small parcels available for sale everywhere, but the supply is low for these as well. If people only want a 20,000 square foot building, a parcel is often three acres. It costs money to split a parcel, and then you have to go through the municipality and have a surveyor go out to redefine the parcel. Depending on how utilities are run, you have to take those into account as well as easements. Sometimes it is easy and clean, but sometimes it can be really messy. People may not want to go through this subdivision process.
It would probably make more sense to try to build a bigger building, possibly in a joint venture with a developer. There are a lot of developers and investors in this asset class that specifically focus on joint ventures. You can work with someone to build one or two buildings, and you can become a partner in that real estate. Depending on the structure, you can either share risk or they can take all the risk and you can become a passive investor. People can get the best of both worlds, where the practice gets ownership but with less risk and responsibility. It all goes back to figuring out if you can find the parcel of land that is the exact size you need for the building that you are looking to build.
If you are looking to own your own building, you are doing yourself a huge disservice if you wait until the last 6 months, or the last 30 days, or your lease. You need to be looking about three years before your lease expires. You need a lot of runway, because the worst way to invest in real estate is when you feel like you are under pressure and have no other choices. You need to be able to meet different people and see who would give you the best opportunity. You need to be able to walk away if something is not a good fit, with time to find another option. 1031 exchanges have some trickiness to them, depending on which side you’re on. It can be a tight window, which also points toward the need for a long runway. You want to analyze the costs and not feel like you have to make a poor real estate decision in order to meet a desired timeline.
[34:04] The spectrum of real estate financing options
Depending on a lot of factors, conventional financing starts at 25% on the low end and then goes up from there. SBA lending is attractive for physicians because they are small business owners, for the most part.
[34:56] Tax advantages with physician ownership
Depreciation can be huge for physician owners. You can deduct property taxes and interest. There are a lot of advantages, and I try to stay in my lane and out of the accountants’ lane. With the disclosure that this not tax advice, a lease is also a way for them to have income that is not taxed at ordinary income. They can get rental income that goes through an LLC, so they can take some of their operating income without it having to go through a W2.
[39:13] Addressing obstacles for physician ownership
Grant thinks the hurdle for most people is that ownership requires a down payment and a lot of work. Even if you hire a property manager, it takes a lot of effort and a degree of risk when it comes to setting everything up and not being able to call a landlord when something breaks or doesn’t suit your needs.
There are so many decision-making factors regarding what makes the most sense. If you can own property, it makes sense financially. There are landlords, of course, that recognize that the tenant is the value in a medical office building. In some brand new buildings, you can sign a long-term lease and also get some amount of ownership. If there is a development opportunity with land, there are a lot of developers that are very interested in partnering with physicians and they would give them ownership. There are lots of ways for physicians to own property while mitigating some risk and capital outlay.
[42:56] Where physician owners can get into trouble
If they are not familiar with the construction process, they don’t know some of the questions to ask. Some of the value you get with joint venturing includes really having the time to interview developers or general contractors, and fully understanding the costs involved. You want to have a contingency amount, because construction is never a straight line. Because of the labor shortage, you wouldn’t want to be stuck halfway through a project and not be able to finish it. You also want to make sure you work with an architect that has built a medical building before. They should know what physicians and patients are looking for and how the medical building should function. Finishes need to be durable, and you might have to accommodate walkers and wheelchairs. People do get sick in medical buildings, so you want to use materials that can be easily cleaned.
With purchasing pre-existing buildings, it is important to know where the building is relative to where you want to be, and how expensive it is going to be to get there. If you are a cardiology practice and you have to send patients for diagnostic testing, you want to have rooms with all the equipment in there. What will it take? Not every building can be an imaging building. There has to be a certain amount of power to the building, and it can be a huge expense to bring it in from the street. If you want a surgery center, you need to have a procedure room. You need to have a backup generator and its own HVAC, and you need space for these things. If you don’t know what you’re doing, sometimes those mistakes could be expensive to correct.
[47:07] The benefits of hiring real estate experts
If you are working full time, I highly recommend that you hire real estate experts. Even if you are well-versed in real estate and feel that you could do some of it yourself, I think you have to ask yourself how valuable your time is. It could be anywhere from a part-time job to a second full-time job, and you have to consider whether you want to take that on or hire people that can be working alongside you during daytime hours. They can communicate with you and you can make decisions, but you spend maybe 30-60 minutes on them rather than hours or days. It’s a lot like financial planning. Other people can do it, but they don’t really have the time to sit and spend time on it. Our time is valuable, and people have different expertise that can be beneficial.
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