Build Medical Office

[Physician Finance Basics]

Hi forum braintrust,
I'm posting on behalf of my husband. They are a small independent group that is now 5 years old. They've been renting their office space for this duration and now want to buy their own space. Since there is no pre-existing building appropriate for them in the location they're interested in, they are thinking of a new building, big enough only to house their own practice (about 7500 sq ft). There is a lot for sale with a tear down on it. How do you figure out if it's a good financial decision? What numbers do you look at?
I know for commercial property you look at certain numbers. But with one's own practice, is the analysis any different?
Thank you, in advance, for your help!
PFB

[Physician Finance Basics]

Bumping for myself

[Steven Podnos MD CFP]

As an initial rough guide, figure out the annual cost of owning the building vs. the current cost of what they are renting. If the numbers are "close", then building probably is a good financial decision.

[familydocPA]

You'll have to run the numbers.

Real estate is a great investment (especially commercial real estate) when you have a stable, long term tenant. If the group is established and stable, you might have more confidence in your investment. If you have any doubts as to the 10-20 year horizon of the group, you might be less optimistic.

[Random1]

I am not an expert , but the practice should not build a building , set up a separate real estate partnership to purchase the land and build the building. As listed above , real estate is a great investment especially if you have no tenant issues , since it will be yourself or your partners.

Determining which of the partners want to be owners and put up capital for the building might be the harder part.

I would look at it from both ends, will the real estate partnership make money? Is the rent appropriate for the practice ?

Passing income through to your real estate , in the form of higher rents, and distributing it to partners through real estate dividends should decrease the amount of taxes you pay for the same income, instead of distributing it through W2 practice income.

[jhwkr542]

The numbers are similar for commercial properties, but you know the rent you'd be collecting ahead of time, so that's 1 variable out of the picture. I think the biggest issue with your own building is if you outgrow the building or something happens to the practice, could you fill it? Around our neck of the woods, office space is so incredibly cheap right now that it's hard for us to justify building.

[Tim]

The separate ownership participation has normally been recommended. One topic that needs to be thoroughly defined is the exit terms. Eventually there will be changes or dissolution.
Think of it as a marriage. A nasty divorce can completely destroy any previous financial benefits. When a new partner come in or a partner leaves, those need to be defined. The heir of a partner will have a different opinion for sure.
Lock in the agreement. Some use a life insurance to cover estate buyouts. The exit has to be defined.and be in the agreement.

[CREGuy]

It really comes down to running an analysis of cost to rent vs. cost to own. Figure out what their current costs are to rent, compare that with what their costs will be to own. When doing this, make sure you're taking into account all costs. Owning a building means that they're going to be covering taxes, insurance, landscaping/snow removal, parking lot repairs etc. (They may already be covering these depending on their current lease structure). In addition, they're going to be responsible for all structural and capital improvements on the building as time goes on, so you'll want to work in some sort of budgeted amortization for those items (roof, HVAC, etc.). You'll also probably want to plan on a remodel of the interior aesthetics at some point down the road as well.

If you run those numbers and you get to a point where owning is equal or cheaper than renting, it's probably worth considering. Without knowing any details, I think it's likely going to not be as attractive as you might think. If they were willing to build a larger building and bring in other tenants to subsidize everything, the numbers get much better, but for a single tenant owner occupied venture, I would guess the numbers aren't going to be that attractive. With that said, it does give you more options. I've worked with a lot of different groups over the years (not just medical groups) on sale leasebacks towards the end of a career/leadership group. For example, if the numbers end up being pretty comparable to build lease, and they choose to build, they could operate in the new space for 20 years while they continue to pay down the debt on the property and when the partners are nearing retirement age, do a sale leaseback on the property. You'll get a premium for the real estate, cash out that portion of the partnership, with no material net impact on the value of the practice. You solve the problem of buying out any partners and valuing the RE, and go back to the flexibility of leasing for the next group of ownership.

I tend to get a bit long winded on these responses, but I do want to say that this isn't the same rent vs. buy decision most people make with housing. When it comes to CRE, it's not always better to own rather than lease, even if you plan on staying somewhere for a long period of time. It requires a thorough analysis using the unique variables of each situation. I often see the pros of leasing space overlooked by groups in the situation your husband is in. Leasing space requires less capital outlay upfront, you can often get significant Landlord contributions upfront AND ongoing, you expense your entire rent payment every year, and you have the flexibility of being able to relocate easily if you need more/less space, a new location, or if a simply a better opportunity comes along. From a partnership perspective it also makes it much easier to divest interests.

[Physician Finance Basics]

Thank you very much for all the insights!
I do not think the numbers will look good compared to leasing. They want to own their space for the same reason most people want to own homes for the long haul.
I think they need to sit down and crunch the numbers. This was really the crux of my question. Whether owning office building is only a financial decision or not.
Things to figure out:
-Cost to lease x 10 years
-Cost to own x 10 years
-Buy-in and buy-out terms
-Tax benefits from owning

Thank you- will update if we make any progress on this front.

[EntrepreneurMD]

The true answer is going to be a bit more loaded than just financial considerations of rent vs. lease. There are organizations that prefer to rent, mainly due to lost opportunity cost if they tie up their money in real estate and others that look at the real estate as a valuable asset due to investment appreciation, dividend (receiving rent or saving rent that would have been paid to another), and tax depreciation.

So in order for the group to make the best decision, the important question is what are the reasons they want to buy their own space? Do they want to benefit from the lease income that is currently going to someone else? Do they want a higher profile location or move closer to a hospital? Do they not want to be subject to the preferences of a landlord that may eventually want the space for himself or is there going to be a significant jump in rent upon renewal? Is the current amount of space or parking becoming an issue with no appropriate current alternate structure available (as you eluded to)?

Most of us speak from personal experience. I have always owned my own real estate, set up as a separate LLC from the practice. I always liked the fact that I didn't pay rent to anyone else, and benefited from annual tax depreciation. Initially the 2800 sq building I occupied (with a mid-level) worked for 7 or 8 years. We expanded a lot of services over that time frame, at which time we started getting tight on space with more patients, more employees, ancillary subcontractors, parking became a problem, etc. I do not like the idea of having to move a practice, and with over half my career still ahead of me, I decided to build but to make sure I didn't run into the same problems again.

I purchased a lot with plans to build something triple the size, incorrectly assuming that was good enough to carry me the rest of my career (you will see why that was incorrect as you read). God seems to have a way of changing our plans for the better, if we're not stubborn. Several potential medical tenants came to me given the high profile location, asked me to build larger and they would rent. Lo and behold, they all agreed to sign leases before I started building. I had to buy the adjacent lot to accommodate their spaces. The project swelled to 16K sq ft. The County told us we were required to have 75 parking spaces, I told the builder to put in 100 - 1 big problem solved.

Now, 3 years later we're all in the building with their 5-10 year leases. The tax depreciation is optimal. My practice is only occupying about 5K sq ft currently. The greatest financial benefit has been the business expansion due to the extra space and high profile location which we would not have otherwise had. I'm currently at a point where I would welcome a tenant vacancy, as we've grown fast. No tenant has suggested they want to leave and if I get in a crunch, the benefit of the second lot purchase means I can still add on a few thousand more sq ft if desired. Things went better than expected.

Now some financial considerations. Yes, I tied a few million dollars in this project. I know you said the practice is not interested in being a landlord. That goes to my point of benefits beyond the groups rent savings versus paying rent to themselves. If my practice expands into the entire building over the remainder of my career (2 decades) our revenues would more than quadruple without having to worry about rising rents, being kicked out by a landlord, parking, location, space, etc. For me there is also the added benefit of not just the financial benefit of healthy commercial rent payments, but given they're complimentary medical tenants we get plenty of referrals as well. They should think like businessmen, not doctors when it comes to RE/expansion planning.

So if it's just a matter of rent savings for the group and not much else, the benefit to ownership is quite limited. Given other considerations, the benefit of ownership to me have been far greater than a simple rent vs. mortgage calculation. One complication for you (as you're already aware) is they are a group versus my project as a single owner, so buy-in and buy-out is a consideration I did not have to deal with, but workable.

[Physician Finance Basics]

Thank you for detailing your experience. Congratulations on it being such a success.
1) the group will likely have to move from their current space- since it's getting tight. Or maybe they can occupy an additional unit in the same building. But the building is older and while functional, not so pretty- inside or out.
2) They want to stay in the same area- it's great for their purpose.
3) Their current rent is pretty low- this keeps their overhead low. This is why I think the numbers will not be attractive when comparing with build. We should probably compare with a different leased place- bigger, with likely higher rent- to be more realistic.
4) One thing that worries me is that there is a great degree of consolidation by the two big hospital systems in our city. Loads of pvt practice have been bought up. Hopefully they will buck the trend- but it's hard to predict. This reduces the time period under consideration and reduces the number of available medical tenants/buyers when they're ready to sell.
5) They're a small group and work very well together- so I think the terms of buying in or out will not be such a sticking point, hopefully.