Who'll buy your medical building, Doctor?

The new partner isn't interested in purchasing your stake. So how do you unload that white elephant?

By Robert Lowes
Midwest Editor

In the mid-1980s, Indianapolis cardiovascular surgeon John Pittman embarked on a real estate adventure that didn't end quite as he expected.

Pittman was one of about 80 physicians who had invested in a new, five-story medical office building on the campus of Methodist Hospital. Those doctors and several dozen nonowner physicians occupied the building. At the time, Pittman's game plan was a familiar one in medicine: When he was ready to retire, a younger surgeon would join his practice and buy his share of the property.

The building eventually filled up with 175 doctors, but over the years the number of physician-owners dropped to 55. Young doctors in Indianapolis, like young ones everywhere, became increasingly loath to invest in medical property. "I don't think they have any spare cash," Pittman says.

Fortunately, a real estate investment trust (REIT) bought the building in 1999 for $26 million. That allowed Pittman to cash out with around $300,000 when he retired the same year. Such a happy ending, however, isn't guaranteed for tens of thousands of other doctors who worry that their office buildings have become white elephants. The medical real estate scene has gotten so dicey that it inspires cynicism.

"What's the difference between a medical office building and venereal disease?" jokes Santa Rosa, CA, practice management consultant Keith Borglum. "You can get rid of VD."

Black humor aside, there are things you can do to unload your interest in an office building when you say goodbye to your last patient. With a little luck and creativity, you may convert a new practice associate into a buyer. As a last resort, you can turn to any number of businesses, including REITs, who have spotted opportunities in sometimes-maligned medical office buildings.

Whatever you do, begin planning your real estate exit strategy today. As in most endeavors, timing is everything.

Young doctors have many reasons for not buying

Considering the limited appeal of medical office buildings on the open market (see below), doctor-owners have traditionally counted on younger colleagues to step forward as buyers when retirement drew nigh.

Today's young physicians, though, are more inclined to be salaried employees rather than partners. What does that have to do with medical real estate? For years, when a group practice brought in a new associate, it often made buying into the building a condition of partnership. Or if not a condition, at least a strong expectation. These days, by sidestepping partnership, young doctors sidestep building ownership, as well.

But even young doctors who do become partners resist sinking money into brick and mortar. The doctors are just too financially fragile. "They come out of medical school with too much debt, and the banks won't lend them money to buy property," says psychiatrist Richard Treadway, chairman and CEO of Nashville-based Medical Properties of America. Plus, young doctors worry about the future of medicine. Will insurance companies continue to whittle down fees? Will nurse practitioners render physicians obsolete? "The uncertainty makes doctors ask, 'Why buy a building?' " says practice management consultant Michael LaPenna in Kentwood, MI.

"If young doctors have any discretionary money to invest, they're more likely to put it into a bullish stock market, where they can earn a bigger return," says Keith Borglum. "And unlike a building, stock is highly liquid."

If anything, medical buildings have become a less attractive investment than ever. Owners once could charge certain tenants—high-rolling specialists, for example—exorbitant rents in exchange for sending them patients. "But those deals have been Starked and prosecuted away," says Borglum. Likewise, owners once reaped juicy tax breaks, such as the ability to deduct passive real estate losses from other income, until this and other benefits were wiped out by tax reform enacted in 1986.

Granted, young doctors haven't stopped buying into medical buildings entirely. But many properties erected 20 or 30 years ago don't appeal to them because they're too cramped for medical practice in the 21st century. "Today's doctor sees more patients per hour, so he wants twice as many exam rooms as a doctor in 1975," says Atlanta health care architect Richard Haines Jr. The use of nurse practitioners and physician assistants, as well as office procedures such as flexible sigmoidoscopies in primary care practices, also translate into a need for more exam rooms. "New doctors want a building they can grow in," says Haines.

How to make a weak seller's position stronger

So maybe it's not a seller's market when it comes to your medical building. But you don't have to take this bad news lying down. Here's what you can do to coax young doctors into a buying mood.

Keep your building in tip-top shape. "I tell doctors that whatever amount they claim on their tax returns for property depreciation should be put into an upkeep fund for things like new carpets and tuckpointing," says Keith Borglum. "Have the doctors make a small contribution to this fund each month. That's easier than asking them to write a $5,000 check every few years."

Discount your price. "Let's say you're asking an associate to kick in $100,000 for your share of the building, and the return on investment is only 4 percent," says Borglum. "The associate assumes he could invest that money in stocks and pull in 15 percent. So lower your price by 11 percent—making it $89,000—to make up the difference. You've given him the equivalent of a 15 percent rate of return for only one year, but that's still worth something."

Spread out the payments. Let the new doctor buy in over five or 10 years to minimize the financial pain. Medical real estate developer Edward Anderson in Temecula, CA, offers this variation: Ask the new doctor to pay $1,000 a month until he's accumulated the necessary down payment. He's then in a position to convince a bank to lend him the rest of the money.

Finance the deal yourself. If an associate borrows money from a bank to buy into a building, the bank will charge him an origination fee worth one or two points, and it usually will force other expenses on him, such as the need for a formal appraisal, says Al Zdenek, a financial planner in Flemington, NJ. "Pretty soon, you've added $10,000 or $15,000 to the cost of the buy-in. You can save the associate that money if you play the banker. Be sure, however, to charge him the same interest rate that the bank would."

Ease future practice partners into building ownership. "You don't want to scare new doctors away from your medical group by demanding that they buy into the building as soon as they become partners," says Cincinnati practice management consultant David Scroggins, with Clayton L. Scroggins Associates. "Tell the associate that the day he makes partner, he has a three-year window to invest in the building. If he doesn't take advantage of his option, he must sign a 10- or 15-year lease."

Zdenek advises group practice doctors to begin selling associates on the idea of building ownership from Day One. "All too often, associates are kept in the dark about building buy-ins until they become partners. Then they're shocked by the amount of money they're expected to invest," he says. "More than that, they don't understand the benefits of building ownership, such as having control over the property. I counsel partners to invite associates to the group's business meetings so they understand all financial facets of the practice, including real estate. That way, they'll be less resistant to a building buy-in."

Plan ahead for current owners to buy you out

If, despite your best efforts, you can't persuade a new doctor to purchase your stake in a building, your real estate partnership should have a mechanism for the other building owners to buy you out.

Such a provision doesn't apply only to retirement. What happens to your building equity if you decide to move to a new city? Or if you become disabled, or die? Answering these questions is easier if you know exactly what your equity is. So make sure owners as well as nonowners have signed leases and are paying rent, even if they're paying themselves, advises medical real estate developer William Molloy in Phoenix. "The value of the building is based on the income it produces. The leases define the income stream."

Now let's consider the retirement scenario. The real estate partnership agreement should stipulate that if no outside buyer steps forward, the other owners must purchase the retiring doctor's share in the building, says Molloy. However, the price should be discounted—perhaps to 90 percent of market value.

Molloy offers two reasons for the discount. "If the owners sold the building outright to another party, their payout would be reduced by a variety of costs associated with the sale, often split between buyer and seller," he says. "The discount ensures that the retiring doctor who cashes out is no better off than an owner who sells on the open market. Plus, the remaining owners deserve the discount—they have to come up with the money to buy out the retiring doctor, regardless of their own financial situation." The real estate agreement could establish the same terms for a doctor who quits practicing because of a disability, he adds.

But how about a 42-year-old doctor who wants out of the real estate partnership because he needs the money, or because he wants to start a new practice on the other side of town? Here, the real estate agreement should be less generous. "You might decide not to buy someone out under these circumstances," says Molloy. "That doctor might have to remain a real estate partner with no voting rights. Or, if you structure a buyout, you might pay him only 75 percent of market value for his share."

In the event of a building owner's death, his ownership stake will likely pass to his heirs. But that situation may leave both the heirs and the surviving doctor-owners unhappy. The heirs might have preferred to inherit cash, not bricks and mortar. The doctors, in turn, may complain that their new real estate partners don't understand or share their medical perspective on the building. The win-win solution: While everyone is alive and well, buy key-man insurance on each doctor for an amount equal to his ownership stake. If one doctor dies, the remaining doctors collect on the policy and use the proceeds to buy his interest in the building from the heirs.

Get your leasing act together before turning to the open market

Instead of cashing out in piecemeal fashion, doctors who own the building they occupy can simply sell the property—lock, lobby, and elevator—to someone outside the medical profession.

Yes, there are companies that might—with an emphasis on might—find your building appealing. Because doctors tend to practice at the same location for years, if not decades, and because they generally have no problem paying rent, they represent ideal tenants, says developer Edward Anderson. And if the building is the right size, well maintained, fully occupied, and set in a prime location—next to a thriving hospital in an affluent suburb, for example—it's even more attractive.

Nonmedical buyers range from life insurance companies with diversified real estate portfolios to companies that specialize in medical buildings. There's even a niche within the medical real estate niche—health care REITs that buy and manage physician office buildings, nursing homes, and hospitals.

If you're looking for such a white knight to round out your retirement plans, don't hang a "for sale" sign at the last minute. Plan on selling the building about five years before you and your real estate partners begin to retire. The white knight doesn't want to purchase a building just to see it empty out a few months later. He wants the sellers locked into leases that will ensure a steady stream of revenue.

Accordingly, doctor-landlords should formally lease their property to their medical practices before selling out. Leases not only give the buyer a promise of future income, they help the seller arrive at an asking price, since the rental income specified in the leases establishes the building's value. Don't make the mistake of charging yourself rent that's far below the market, warns Indianapolis real estate broker M.E. Thomas Jr. "That just deflates the value of your building."

Besides defining the building's worth, the lease protects you after the sale in two ways. One, the buyer takes over the lease, and while it's in force he can't raise your rent, although your lease should allow for cost-of-living increases. Two, the lease spells out the obligations of both landlord and tenant. "The lease might require that the landlord provide janitorial service," says William Molloy. "That prevents the new owner from announcing that the tenants must pay for janitors themselves."

Should you take the cash and run?

Putting your building on the open market won't guarantee a truckload of offers, even from the niche dwellers. Companies shopping for medical property are choosy. More than anything, they want big buildings. MPA focuses on those between 20,000 and 100,000 square feet. That criterion would rule out structures designed for fewer than 15 doctors, notes MPA's Richard Treadway.

Likewise, health care REITs tend to steer clear of smaller buildings. Nashville-based Healthcare Realty Trust generally doesn't look at buildings worth less than $1 million. Lillibridge Health Trust in Chicago limits itself to medical office buildings on hospital campuses.

Once you receive offers, it's your turn to be choosy. Some buyers, such as MPA, will pay you in cash. Private health care REITs may give you a choice between cash or partnership units that yield from 7 to 11 percent. Public health care REITs, cash-poor these days, may offer shares only.

Ask a tax-savvy financial planner to help you weigh the offers. If you agree to a cash offer, you're subject to capital gains tax. You can defer or even avoid the tax if you accept REIT units. The value of the units or shares may be bigger than any cash offer, but of course cash is far less risky. Deciding what to do forces you to research the REIT, just as you would any other investment.

If you're leery of both shares and cash—and would like to avoid the capital gains tax—see whether the buyer can simply give you a nonmedical, income-producing property, like a warehouse or drugstore, in exchange for your building.

While you're evaluating offers, ask yourself this, as well: Will that buyer do a good job managing the building after the sale? Talk with other doctors who've sold their property to the prospective buyer and ask about his track record as landlord. The last thing you need in the twilight of your career is a patient tripping over a tear in a worn-out carpet. You might wish you'd held on to your building.

Owning a medical building: The pros and cons

Don't be surprised that younger doctors would rather rent than buy. They've probably listened to practice management consultants who say that the disadvantages of building ownership outweigh the advantages.

First, the advantages. High on the list is autonomy. You want a working environment that you can shape to suit your needs. "A physician needs to chop up his interior space into lots of exam rooms, each with its own sink," says Cincinnati practice management consultant David C. Scroggins, with Clayton L. Scroggins Associates. "Plus, a doctor's building generally requires twice as many parking spots as a regular office building. In some communities, doctors can't find the right facility on the rental market, so they're forced to build."

Having a landlord, in contrast, can pose a liability. Besides vetoing your plan to add, say, an extra building entrance, he may raise your rent to intolerable levels when your lease is up. Or he may simply boot you out—a serious disruption to your practice. So control is no small thing. "Most doctors who purchase a building are motivated primarily by nonmonetary factors," says health care attorney David Schiller in Norristown, PA.

Still, there are some dollars-and-cents advantages to ownership. One, your equity may grow in value. Two, you can lower your practice's tax bill if you pay yourself rent. Most doctors who own their building do so through a real estate partnership that's separate from their medical practice. Cutting a monthly rent check to the real estate partnership reduces your income from your practice—and, consequently, your personal income tax. Yes, this maneuver increases your profit from the real estate partnership, but partnership income isn't subject to payroll taxes, such as those for Social Security and Medicare.

That said, owning your medical office building has serious drawbacks. Strictly as an investment, it may generate a pathetic return. "Let's say you buy the property for $500,000," says Schiller. "Your annual rental income is $100,000, but your building expenses are $90,000. The $10,000 profit is a 2 percent return on investment. That's worse than a certificate of deposit."

Medical-office ownership also violates the investment principle of diversification, adds practice management consultant Michael LaPenna in Kentwood, MI. "You're getting income not only from your medical practice, but from a building in the same industry," says LaPenna. "Furthermore, you're not geographically diversified. An economic downturn in your region could lower both your occupancy rate and practice income."

What's more, do you really want to be a landlord? This is a managerial role that can distract you from medicine. "I've seen doctors plowing the snow off their office parking lots, thinking they were saving money," says Brentwood, TN, practice management consultant Randy Bauman. "Seeing patients would be a more productive use of their time. Hire out the plowing."

Some doctors are the absent-minded sort who never notice that the building needs a fresh coat of paint. Others are too frugal to have the job done professionally. "Some doctors nickel and dime their properties to the point of self-defeat," says Michael LaPenna.

If you're making mortgage payments on your property, a mortgage holder may take a pound of flesh out of your financial backside. Greg McGau, vice president of Landstone Medical Properties in Memphis, recalls a 62-year-old orthopedic surgeon who owed $3.5 million on a building. Fearing that the surgeon might die before he paid off the note, the bank required him to buy a life insurance policy for $3.5 million. At 62, the doctor's premium would have been $60,000. He sold the building instead, says McGau.

Perhaps the most galling problem is cashing out when you leave medicine. If another doctor doesn't buy your real estate at the price you're asking, who will?

"Like a restaurant, a medical office building is essentially a single-purpose edifice with limited appeal," says David Scroggins. "And it's far more expensive to construct, because of all the exam rooms, which mean more plumbing and more complicated heating and cooling systems.

"Somebody interested in buying the building and renting to lawyers and accountants won't pay $100 per square foot. He doesn't need the exam rooms; in fact, he'll have to pay to have them torn out and the interior rebuilt. To him, maybe the place is worth $50 a foot. If the doctor isn't willing to lower his price, this kind of buyer won't bite."

 

Robert Lowes. Who'll buy your medical building, Doctor?. Medical Economics 2000;23:77.