Rent or Own: The Eternal Question in Healthcare Real Estate
The building and land that your healthcare business resides on can be crucial to the success of your business as a whole. This is especially true when the issue of renting versus owning the property/building come into play. The Ambulatory M&A Advisor answers some questions regarding the benefits of owning, benefits of renting, and current real estate trends in healthcare.
Joseph Eckelkamp, CPA, owner of Eckelkamp and Associates CPAS says that from a tax perspective there are a lot of considerations that enter into owning versus leasing the property that a healthcare business is built on. As a general rule, Eckelkamp says owning is going to be a better outcome from both a tax point of view and an overall economic point of view.
Some of the tax benefits of owning are that many of the deductions for improvements to the building, things that are not structural components can be accelerated and deducted earlier than they would otherwise be deducted under a lease. He says the ultimate outcome is obviously going to be a function of the lease rate versus the purchase price.
“In a normal situation you are going to be able to accelerate the deductions somewhat under a purchase arrangement,” Eckelkamp says.
“The biggest negative with owning from a tax perspective is unpredictability of deductions. In other words, with a lease, you know exactly what you are going to be able to deduct every year according to the terms of the lease. With owning, it is going to be a function of both depreciation (which is predictable) and improvements or repairs that are unpredictable. You may end up with deductions in a year when income is low, and that would be unattractive.”
If leasing is the only real option, and it can be predicted what types of tax deductions will be available, the question arises of how often the owner of the property or land can change the terms on the renter.
Eckelkamp says there are two answers to this question. One of the answers is that this can only be done in accordance with the terms of the lease.
“If you have a three year lease, you are stuck for three years; if you have a five year lease, you are stuck for five etc. That is the only thing that is a certainty,” he says.
“We have a lot of clients that have leased space because they wanted to be in a hospital campus for their medical office. Pretty typically, what will happen there is if they want to expand or renovate their offices, they will approach the landlord about incorporating the cost of those improvements into their rent. Using an example, they might go from 10,000 dollars a month to 13,000 dollars a month because they have had the landlord pay for improvements, and the landlord factored that in as an increased rental rate. Typically, you will also see the lease term extended under those circumstances. Maybe it is 10,000 dollars for 24 months left, now it will be 13,000 but they have got to extend to a 48 month.”
According to Eckelkamp, the only challenge here is that the landlord is under no obligation to do this. If the landlord says they do not want to do this, then it is no longer an option.
For some leasing can have a negative connotation versus outright owning a property. Eckelkamp says that if leasing is a business owners best option, then they should pursue it.
“There is one other big advantage to leasing if you ignore the tax consequences and if you ignore the economics of the actual cash flow. First of all, there is a certain prestige sometimes associated with being in a particular location. Whether that is because it is a great office building, or more likely in a medical practice, because it is on a hospital campus. Despite the fact that they could buy real estate, a number of my clients have made the decision that it was more important to the success of their business to be on site at a medical center of one kind or another,” he says.
Nathan Palmer, vice president of National UC Realty explains that in today’s world, price is important in the balance of the economics between the required rent commitments versus the value of the space.
Palmer says that while working to help physicians understand that for a slightly higher price point, the physician can have better visibility, better signage, better exposure, and on top of that, own their property, some physicians decline due to the higher cost. Palmer says it is very typical to see people who will sacrifice taking the right space to save money.
“Sometimes it is too expensive, at some point, you have to draw the line, but many times, especially in the smaller units, these companies don’t really have somebody on board who can relate real estate costs to required patient traffic,” Palmer says.
Jonathan P. Lewin, Managing Principal, Chief Financial Officer of MedCraft Healthcare Real Estate says that having a successful building or campus limits investment risk for high turnover and vacant spaces, which is the biggest advantage to owning a building where everyone feels part of the process and partnership.
“I’m not sure there are disadvantages, but there are risks that are inherent with every project. Namely, is this the right location and market for the strategy the hospital is trying to implement? If an ambulatory surgery center is built, but the physicians and patients are slow to ultimately utilize the facility, you may have a very expensive, underutilized and potentially dark space that puts a big, dark cloud on the rest of the building. This could be due to competition in the area, reputation of the hospital, disconnected physician networks and referral issues. The major risk of every real estate project is location,” Lewin says.
According to Lewin, there is never a simple answer to what seems like a simple question: rent or own? He says each situation needs to be evaluated.
“Ultimately a health system, hospital, and physician groups are in the business of delivering health care to their respective communities, not owning, developing, constructing, managing and maintaining real estate. It’s important to utilize a third-party real estate company that understands health care and has the experience of developing projects of all sizes, in different communities, to ensure the project is done right. Buildings play an important role in the community and in efficient health care delivery,” Lewin says.
“You want to have a real estate partner that can demonstrate how particular projects, programs and even floor plans, have helped or hindered a particular strategy, to illustrate how the hospital will save space, time and money both up front and in long-term operating expenses.”
Lewin says the process of developing an ownership in healthcare real estate depends on the hospital and health system. He says some systems have preferred developers and building operators that have been vetted through a request for proposal process.
“Some systems use third-party advisors or brokers to run a RFP process. Others have long successful relationships where the trusted partner provides market-rate terms and is clear and transparent in the transaction,” Lewin says.
As far as the current real estate market in Healthcare, Lewin says real estate has become a preferred asset class and firms that have not traditionally focused on this asset type have attempted to enter the market.
“More speculative medical buildings have been built. More buildings that don’t connect physician groups and hospitals have been built. Experience and longevity through proven relationships should be key for hospitals and health systems looking for the right partner. Merchant developers, or developers who build and sell assets, are in the development business to flip a building upon completion and lease up and turn a profit. Investments from equity firms, REITs, pension funds, life insurance company and foreign capital have driven capitalization rates down and values of buildings up,” he says.
Lewin adds that there are very good capital providers in that class, but they need to be vetted as well. The assets funded by short term real estate capital may sell a building a couple of times.
“This means the hospital lease that creates the value doesn’t gain a thing and has to become accustom to new landlords and management with the prospect of no long-term relationship and partnership on how the building functions in delivering the hospital programs’ strategy. The waters are very warm and inviting, but caution needs to be heeded,” Lewin says.
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.