Leasing vs. buying medical office space

Owners typically have more control over occupancy costs and a shot at long-term appreciation, among other benefits, but experts say it’s critical to understand both the local market and the career timeline of practice partners before deciding. Leasing, particularly over shorter time horizons, can be a much cheaper and safer option, experts say.

It’s impossible to precisely forecast future real estate returns, and there are a host of individual factors that influence whether a physician should lease or own. Local market conditions, individual risk tolerance, likely length of stay in a given location, and the stability of a practice all factor into the decision.

Emotion often plays a role as well, even though practice experts typically try to dissuade clients from clinging too tightly to their biases. “Some doctors just seem to like to own things,” says J.P. Roach, JD, MBA, senior vice president with Hughes Marino, an Irvine, Calif.-based real estate firm. “There’s not much more teeth to their argument than that; they’d just rather own than lease.”

To help make the best decision, consider both the benefits and risks of both options.


When to buy

Roach and other advisers say they typically like to see clients with at least 10 to 15 more years of active practice still ahead of them to make buying the best option. Toward the end of that timeline, mortgages are typically paid off or close to it, with the practice now owning a large share of equity in the office building. Meanwhile, leasing costs have risen most years and the practice has no equity to show for a lease.

The purchase price varies widely by location, of course, but loan terms to physicians tend to be favorable compared with other types of occupants because of their credit history and typically longer lengths of stay, experts say. Hospitals and private equity firms, meanwhile, have been aggressive medical office buyers in recent years, pushing down vacancy rates and boosting sales prices and lease rates in many markets.

“There’s a lot of appeal in this segment for investors because we’re late in the [economic] cycle and medical offices perform better than other types of properties during recessions. That, along with the demographic trends, makes it compelling,” says Andrea Cross, Americas head of office research for Los Angeles-based CBRE Group Inc., a commercial real estate investment and services firm. Aging baby boomers’ increasing health needs are expected to keep demand high for medical real estate, she says, though there will be cycles to the growth.

“Demand for medical office investments is at an all-time high,” says Chris Bodnar, vice chairman and co-head of CBRE’s Healthcare Capital Markets Group. “It’s classified as recession-resistant based on previous market cycles, and investors putting money into spaces are looking at what type of real estate is going to perform best in the near-term. It’s a very good time to be a seller,” he says. And the sector’s ability to withstand economic downturns should maintain its appeal as an investment, he says.

Surging demand prompted CBRE in the summer of 2017 to issue its first-ever industry report on the U.S. medical office market. It found absorption of medical space surpassed supply during the previous seven years, lowering the national vacancy rate to 8 percent from about 11 percent in 2010.

There may also be a bonus to buying in the form of a recruiting tool. “[Private-practice] physicians often can’t offer loan forgiveness, but they can offer the opportunity to buy into a medical office building that builds equity,” says Amanda Waesch, JD, a partner with law firm Brennan, Manna & Diamond LLC who works with clients in several states.

All of my clients who have sold their office properties in the last 10 years have done extremely well,” says Waesch.

The downside? In a word: risk. If a nearby hospital moves, physicians could be stuck with a location that is no longer convenient for patients. Remodeling costs to keep the office attractive fall to owners as well.

And the pace of change within the medical office market has accelerated, increasing occupancy costs and the pressure to move. In a recent Medical Group Management Association (MGMA) poll, more than half of respondents reported they had remodeled their practices’ offices, added square footage or changed location in the last two years to stay relevant to patients, another possible downside to owning
Particularly after several years of expansion, it’s important to understand how a practice that owns its building would be affected by a real estate market reversal, experts say. Physicians who have purchased a building containing tenants, for example, need to be aware that when the market turns down, lease rates they are able to get from tenants will decline as well.
 

When to lease

Leasing is traditionally the safer option, according to Keith Borglum, CHBC, CBB, a longtime practice appraiser and editorial consultant to Medical Economics.

“I am discouraging physicians from owning their own buildings; the main reason being that it puts their real estate investment in the same risk basket as their professional risk. If they become disabled or lose a big insurance contract, their building also potentially loses a key tenant,” he says, meaning that a practice could take a hit substantial enough that it can no longer afford to stay in the building.

Leasing also typically has the advantage of significantly lower costs in the early years, though that often changes if a practice remains in a location long enough. Having an accountant project total costs over time for each strategy, including tax implications, is critical to understanding where a practice’s break-even points are, experts say.

Higher costs for leasing over longer periods compared to purchasing aren’t a given, says Russell Still, CVA, CHBC, executive vice president of Atlanta-based Medical Management Associates Inc. Owners may have a catastrophic event and be forced to sell at a loss, for example, a situation that would be mitigated if the practice leased space on a limited term.

Owners who get in a financial bind could rent the space out to other providers, but the rental market could be soft at that point and not bring in enough income to cover the cost of the mortgage, he says. And over the lifetime of a practice, the neighborhood could become less desirable, depressing resale prices.

He cites the example of a client who purchased a $300,000 building and after 15 years sold it for just $240,000. “It’s half of what he originally expected, but at least he was able to sell,” he says, which isn’t always the case with highly undesirable locations. Selling at a loss can still be considered a win if it’s cheaper than what the leasing costs would have been over time, though opportunity costs associated with tying up money in an owned building for many years would also have to be weighed.

“I think it’s risky for a physician today to own their practice real estate, particularly if they are in primary care or are approaching retirement,” says Mary Beth Kuzmanovich, MBA, national director of healthcare services for Colliers International, a global commercial real estate firm.

Primary care providers, as acquisition targets for hospitals, may find it a messy job to sort out a practice buyout offer if there are different real estate ownership structures for different partners, she says. These details can be written into a buy-sell agreement, but the complexity can be a turnoff for both buyers and sellers, she says.

And when some partners own while others rent, there can be a lot of tension around fair market value as owners may want to see higher rents for tax purposes than what non-owners expect to pay, she says. Again, these arrangements are typically spelled out in practice agreements, but they can be a continuing source of conflict as market values fluctuate, she says.


When to sell and lease

Many physicians use their owned medical office space as a part of their retirement plan, leasing the space to younger physicians to produce a steady income stream when they stop practicing or selling and investing the proceeds. But there are other ways to play the hand, experts say.

For example, if a major hospital is expanding its footprint by acquisition, owners of nearby medical office properties could be in a good position to sell immediately for a strong price, even if retirement is not imminent. In those markets, experts say, physicians may consider selling their buildings and leasing them back from the buyer for the last few years before retirement rather than trying to become a landlord once they are no longer practicing. Similarly, trying to sell a vacant building after a physician retires reduces the pool of potential buyers because there is no longer a tenant. Having or adding practitioners to the practice can mitigate this, of course.

Alternatively, physicians could use their building as a kind of insurance policy by entering into an employment agreement and leasing the office to a hospital rather than selling, Waesch says. If the employment situation doesn’t work out, the physician still owns his or her space and can go back to private practice after the lease terminates.

In the end, experts say, consider what the local market is saying about the type of location that will best suit patients over the long run. In some of the best locations, there simply aren’t buildings available for purchase, notes Kenneth T. Hertz, FACMPE, principal for MGMA’s Healthcare Consulting Group. In others, there may be relatively cheap land in a spot patients will love for years to come. “Is there a glut of office space there or a paucity?” he says. Taking advantage of what you have to work with in your community will pay dividends later on.
While it’s difficult to forecast far into the future where real estate is concerned, it’s important to keep the eventual sale of a medical office in mind when factoring in the needs of a practice’s partners, says Hertz.

Owning a property that houses a large group practice and leases space to other providers is an enviable position to be in today, with private equity investors eyeing these types of properties, he says. That’s because larger numbers of physicians mean larger revenue streams and less dependence on one practitioner. That’s a stark departure from just a few years ago, when some doctors struggled to unload office space after they had moved on to a new practice.

Finally, Hertz says, remember that renting or buying is a business decision, not an emotional one. Lining up the total ­operating costs and tax implications associated with both, and keeping in mind career timelines and current market conditions will help practices discover the right strategy.

Buying could be cheaper in the long run, but leasing a highly desirable location that isn’t available for sale could pay for itself in added revenue.

With this in mind, Hertz recommends a very simple question to the practice financial team to make the decision: “How does it affect the bottom line?”

“If leasing a new space helps you increase patient volume, make sure you project out what it’s going to do to overall costs over time. If the added growth still drops directly to the bottom line, what are you waiting for?”