[Editor’s Note: The deadline for applications for the WCI Scholarship is Saturday. Don’t procrastinate. We could still use a few more judges and donations too.
Real estate and health care are both topics of interest to the WCI Community, so I thought a post that combined the two would be appropriate for today’s guest post. This was submitted by Tyler Rhoades of Montecito Medical Real Estate, a privately held company that specializes in healthcare-related real estate acquisitions and funding the development of medical real estate. We have no financial relationship.]
As a physician, investing in the real estate of your practice is probably the biggest decision you’ll make during your professional career. After spending years in school, countless sleepless nights, and racking up a pile of student debt, making a large investment in your professional home is a monumental achievement that comes with pride as well as a lot of tough business decisions.
This article is written to give you a transparent, behind-the-scenes look at how private equity buyers of medical real estate evaluate and place value on thousands of healthcare properties a year and how you can set your property up to achieve maximum value when it comes time to monetize your practice’s real estate.
How to Maximize the Value of Your Health Care Property
For many doctors we come across, the lingo used in the commercial real estate world is completely foreign to them. If you already know the fundamental basics of the industry like cap rates, NOI (Net Operating Income), and NNN (Triple Net) leases then skip on down to the next section. This section is meant to provide a brief overview of the terms and factors investment professionals use to determine the market value of your medical property (hint… we don’t use appraisals).
Common Terms You Must Be Familiar With
#1 Net Operating Income (NOI)
The annual amount of rental income generated by the property subtracted by the property’s annual expenses.
#2 Cap Rate
The cap rate gives the relationship of one year’s net operating income (NOI) to the lump sum value assuming no debt is placed on the property. The formula to calculate cap rate is:
Cap Rate = Net Operating Income (NOI) ÷ Value
An easy way to remember the relationship between cap rate and value is:
Lower cap rate = higher sales price (better for you)
Higher cap rate = lower sales price (better for the buyer)
#3 Triple Net Lease (abbreviated NNN)
Lease in which the tenant is responsible for all real estate taxes, insurance, and maintenance. This is the most popular lease structure for both tenants and landlord and commands the most value.
#4 Gross Lease
Lease in which landlord is responsible for all expenses including, but not limited to, utilities, maintenance, taxes, and insurance. Rental rates for gross leases are usually higher than a NNN lease. Investors are not favorable towards these types of leases because it means they must commit more time and money to property management.
Transaction where the property owner sells the property in exchange for a new, long-term favorable lease between their practice and the buyer.
Now that you’ve got the basics, let’s take a look at a couple of things to consider when positioning your property to achieve maximum value.
What Impact Does a Lease Have on Your Property Valuation?
Many physician real estate owners we come across don’t fully understand how the market places value on their property. Many of them base the value of their property off of the bank’s appraisal or how much their competitor across town sold his/her property for. While comparable sales are a good indication of market strength, they don’t necessarily tell the full story. Here’s a quick example comparing two similar orthopedic buildings across town that demonstrates why using comparable sales is not a good way to determine value:
Let’s say Building A is a 20,000 SF orthopedic clinic owned by the physician group and built in 2010. The orthopedic group occupies 100% of the building and is located 2 blocks from Hospital A. In November 2018, Hospital A bought the orthopedic group and put a 12-year NNN lease at $25.00/SF/Year with 2.5% annual increases in place between Hospital A and the physician-owners of the building. In March 2019, the physician group sold Building A to a private equity firm for $8,695,650 ($435/SF).
Now let’s look at Building B. Let’s say Building B is also a 20,000 SF orthopedic clinic built in 2010 and owned by a competing orthopedic group across town. Building B is almost identical, located 2 blocks from Hospital B, and is also 100% occupied by an orthopedic group affiliated with Hospital B. However, the lease in place between Hospital B and the physician-owners is a gross lease at $25.00/SF/Year with no annual rental escalations and has only 3 years left on the lease. They also sold their building in May 2019; however, Building B sold for only $5,250,000 ($262.50/SF).
Why the drastic difference if these two buildings were almost identical?
If the physician-owners of Building B were to only determine the value of their building based off of what Building A sold for, they’d be extremely disappointed and would have unrealistic expectations. Most of the time, the terms of a lease are not known when looking at comparable sales on County public record’s websites. Even though Building B has a $25.00/SF/Year rental rate, since it is a gross lease, expenses must be factored into the NOI before calculating value. Assuming $4/SF/Year in expenses, this puts the effective rental rate at $21.00/SF/Year. The short lease term and lack of annual rental escalations for Building B also negatively impact the cap rate thus putting the cap rate at around 8% for Building B. On the contrary for Building A, the lease is structured as a NNN lease so there are no expenses to deduct from the annual rent so the effective rent is still $25.00/SF/Year. The longer lease term and annual rental increases compress the cap rate down to a 5.75%.
Now that we know how the lease impacts the value of your building, let’s look at a couple of things you can do to make sure your building commands a price like Building A!
How to Structure Your Practice’s Lease
The value of your building will be determined by the lease that either you put in place with a buyer in a sale-leaseback transaction if you’re a private physician group or the lease you negotiate with the hospital if you’re a hospital affiliated group. We’ll look at best practices for both unaffiliated groups and affiliated groups as both situations have different metrics and methods to attain maximum value.
If your practice is affiliated with a hospital system and you own the real estate, the most important thing for you to achieve maximum value for your property is to focus on timing. I cannot stress this enough. Because you’re at the mercy of the hospital that owns your practice to put a lease in place, knowing when your lease is coming due and being prepared for the negotiation process is essential. Here’s a breakdown of everything to consider when the value of your real estate depends upon establishing the best lease with a hospital.
You should aim for a term of at least 10 years. Even if you have to sacrifice a couple of $/SF/Year in rent during negotiations to achieve this term, the cap rate compression from a 10+ year lease will outweigh the slight decrease in annual rental income.
#2 Annual Rental Increases
Annual rental increases are essential to adjust for inflation. On average, annual rental increases are somewhere between 2-3%. Anything less than 2% will negatively impact the cap rate. While some leases will define a fixed annual percentage increase, some leases will use what’s called a CPI (Consumer Price Index) rental increase. This is where the annual rental increase fluctuates with whatever the CPI is at the given time. Personally, I’m not a fan of CPI increases because they can get too complicated when trying to calculate next year’s rent and it’s just one more thing that can cause problems on down the road with a lease. However, some hospital systems only use CPI increases. If your hospital system is insistent upon using an annual CPI increase, consider setting minimum/maximum caps on CPI. A common cap we see a lot is a CPI increase that cannot be less than 2% and no more than 3%. That way if we fall into another 2008 recession, your annual percentage increase will never dip below 2%. When we see this as a buyer, we will underwrite the annual percentage increase at 2.5%. Also, never ever agree to a lease that does not have annual rental increases. Not only is that not Stark Law compliant (more on that in a second) but it will also cause the cap rate to increase 40 to 50 basis points or more.
#3 Stark Law
As providers affiliated with a hospital system, I’m sure you’re well aware of the Stark/Anti-kickback laws. When it comes to real estate, the Stark Law states that the rental rate must be Fair Market Value (FMV). Usually the multi-million-dollar settlements you see in the news are for hospital systems leasing space from physician-owners at a rental rate way in excess of FMV in exchange for Medicare referrals.
However, FMV also applies to hospitals leasing space at below FMV and this is something you can use to your advantage. If other hospitals in your area are leasing similar space from physician-owners at an average of $24.00/SF NNN on a 10-year term with 2.5% rental increases, then your lease must be within that FMV or else the hospital could be guilty of a Stark Law violation.
If you’re renegotiating your lease and the hospital system will only give you a 5-year term and you know the market term for your area is 10+ years, consider having a FMV rental rate study done. Not only will this help alleviate potential animosity during negotiations between you and your hospital employer by agreeing to defer to a 3rd party, but it will also be beneficial for the hospital to have proof that their leases are FMV and Stark Law compliant should they ever be audited by CMS. The hospital will appreciate the risk-management benefits of a FMV rental rate study and you’ll most likely get the lease you want if you’ve done your homework.
#4 Timing (Once again!)
If you’ve just secured a 10+ year lease with favorable terms, congratulations! You’ve just set your property up to achieve maximum market value. Now you have a decision to make. Do you continue to enjoy the continued stream of rental income for 10 years or do you consider selling while it’s most valuable? You and your partners need to have an honest, open discussion about a liquidity event and explore where you’re at in the current real estate cycle. Putting off this discussion could hurt your value as the market value of your property slowly declines for every year that ticks off that new 10-year lease.
Private, Unaffiliated Practices
Unlike practices affiliated with hospital systems that are at the mercy of the hospital when it comes to establishing a lease, private practices have a lot more flexibility when it comes to timing. Since unaffiliated practices’ leases are usually between the real estate ownership entity and the practice entity, these leases can be dissolved at pretty much anytime and replaced with a more favorable lease when the ownership decides to sell. However, even though there is more flexibility there are a couple of key things to consider that could impact the value of your property in a sale-leaseback transaction.
#1 Establish a rental rate first before setting a target price
In a sale-leaseback transaction, you will become a tenant and will be paying rent to the new property owner. If you solely focus on the sale price of your property and not the amount of rent you’ll be paying over the term of the lease then you could find yourself in a world of hurt on down the road. Going back to the cap rate equation, you can get to any price you want on paper essentially by setting your rental rate to achieve an NOI that will get you there.
For example, if you have a 15,000 SF building and the market cap rate is around 7% at the time and you decide you want $9.6 million for it, then you’d have to set the rental rate at $45.00/SF/Year to achieve that price. Now while $9.6 million might be a huge payday for you and your partners, can your practice afford to pay $675,000 in rent every year? Being realistic with rental rates and thinking long term will be more beneficial for both you and your practice in the long run. Another consequence of setting the rental rate too high could turn away buyers and negatively impact your cap rate.
When we underwrite sale-leaseback properties to purchase, we always check to make sure the rental rate is within market rates for the area. If the rental rate is too high, we will add 50 or so basis points to the cap rate to account for the risk that the tenant might break their lease because the rent they set is too high and jump ship across the street to a cheaper location.
#2 Give yourself control over the property
In all sale-leaseback transactions, it’s important to give yourself full control over the property for years to come. Not only will a 15-year lease command a premium price, but it will ensure that the new landlord and those to come cannot raise your rent or kick you out of your own property that you built. Nobody can change your lease once it is set, even if you go through two or three landlords during that 15-year lease. When we work with groups to establish their lease with us, we always recommend a 15-year lease with five to six 5-year options to renew. This gives them full control of the property for at least 15 years and all the way up to 30 additional years if they so choose.
#3 Weigh the pros/cons of using a broker
As you can see, both affiliated and unaffiliated practices have a lot of different ways to create value, but you must know what your goals are for the property and have a plan. Signing a bad lease with a hospital could decrease the value of your property by over $1 million. By having an exit strategy and knowing how to attain maximum value you’ll be able to position your property and your practice to unlock the full potential of your medical building.
How has your practice structured its lease? Why? What pros and cons have you found? Comment below!