“Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”
Granted Mr. Carnegie’s statistics predate Silicon Valley by a century or so, but he still makes a compelling argument for real estate ownership. Then, why have so many successful business owners made the deliberate decision to lease their real estate rather than own it? When physicians, hospitals or other care-providers need space, they have a choice whether to lease or to own the real estate that they occupy to deliver care and conduct business. There are both financial and operational matters to consider. The criteria for making the lease-versus-own decision may be different for a physician than it would for a hospital. In this article we examine the motivation as to why a physician practice, a hospital or other care-provider might elect to own versus lease. We also present factors to consider that might help an end-user to make a more informed decision.
Invest Where Your Bread is Buttered
Astute business owners may choose to lease instead of own so that they can preserve available capital to invest in their operating business which, in many cases, will deliver a higher return on investment than an investment in real estate. Hospitals and private practitioners alike should consider their capital needs before investing in real estate. Real estate is a capital-intensive investment and is usually financed in large part with debt. For hospitals, the debt might be in the form of tax-exempt bond proceeds. For a physician practice, it might be a mortgage loan with personal repayment guarantees. In either case, a real estate investment may tie up equity for a long time or limit credit capacity of an organization or its principals, which could limit opportunities to reinvest in the business and grow revenue. While real estate can be a sound investment, a business owner should consider whether the highest and best use of their money is in their business, or in their building. The CCIM published an excellent article, “The Lease Versus Own Decision” which addresses more fully the financial analysis of the decision, not specific to health care. https://www.ccim.com/cire-magazine/articles/lease-versus-own-decision/?gmSsoPc=1
Things Change, Buildings Don’t
Ventas (NYES: VTR), a publicly traded REIT, owns over 1,200 medical real estate assets and is widely recognized as a successful company. Yet, Ventas leases their corporate headquarters. When it comes to their primary place of business, an owner should consider operational issues that might make leasing more practical than owning. Take, for example, two identical physician practices each of which require the same amount of space. One group enters a lease for five years, we will call them the Lessors. The other group, we will call the Owners, develops and owns a building of equal size. After three years, both groups unexpectedly recruit two more doctors to their practice, and each find themselves in need of additional space.
The Owners have a few options. They can sell their building and relocate to larger space. They might expand their building if land is available and if they have the capital to do so. They might split the practice into two locations. They could vacate their building, continue to own it and lease it to another tenant. Or they can just squeeze in tight and get cozy at work for an indefinite period of time.
The Lessors have a different set of options. They can ask their landlord to relocate into a larger space in their existing building or expand into an adjacent suite. They could split the practice into two locations. Failing those alternatives, they can negotiate an early termination of their lease and find space elsewhere. Or they can squeeze in tight and get cozy for a finite period of time, two years, the remainder of their lease term.
The point is that real estate is an illiquid asset, yet a business’s space needs may change over time. Finding the right buyer can take a long time, especially for a vacant building. The Owners might feel pressured to accept a lower offer just to solve their immediate space problem. They may find themselves in a weakened negotiating position as a motivated seller. The Lessors, however, are approaching their landlord as a growing business willing to take more space and pay more rent. The landlord does not want to lose a good tenant. Competing landlords would welcome this tenant. The Lessors are in an advantageous negotiating position. An organization might limit their flexibility by owning its primary place of business, which is another reason businesses elect to lease rather than own. A real estate investor should consider potential conflicts of interest that may arise when their investment is also their workplace.
Mind Your Own Business
With real estate ownership comes management obligations. When the air conditioner breaks down in August, a tenant need only call the landlord and complain. An owner-occupants must take care of the problem independently. In addition to routine repairs, a building owner must handle payment of property taxes, insurance, janitorial, landscaping, capital expenditures, utilities, mortgage payments, accounting and the distribution of operating proceeds. If an owner admits other tenants to the building, they also become a landlord. They must handle all items on the list for their tenants, as well, plus leasing and lease administration. When evaluating the decision to lease or own, consider carefully if you have the available resources within your organization to properly manage a building without distracting from the management of your practice.
One solution is to hire a professional property manager. Many landlords charge back the cost of property management to their tenants, anyway. You might find that owning a building and hiring a good property manager is cost-neutral to renting space and paying a landlord for the same service. Be aware that a well-managed property goes mostly unnoticed, but a poorly managed property will aggravate employees, annoy patients, distract care-providers and could ultimately harm your primary business.
It’s About Control
Even if a hospital does not occupy space in the building, an on-campus medical office building is so closely linked, sometimes literally, to their adjacent operating business that they may be reluctant to relinquish ownership. A hospital may choose to own a medical office building, or to retain ownership of the land beneath it, so that they can control the activity within that building and control the quality of the built environment on their campus. Most hospitals impose use-restrictions upon physician tenants on campus. These use-restrictions, usually found in the lease or the ground lease, commonly include limitations on services and activities that may be performed within a doctor’s office that would compete with services offered by the hospital, or prohibit tenancy of known; non-medical uses; or occupancy by doctors who do not have or have lost their privileges at the hospital.
So, in this wonderful free-market economy, one of the reasons a physician might prefer to own their building, or to lease in location off-campus, is to avoid these restrictions and be free to do whatever they may choose to do within their space. The delivery of health care, and the technology used to deliver care, changes rapidly. While use-restrictions may protect a hospital’s business, they might limit a physician from offering new services or capturing new revenue streams from technologies that have not yet been invented. In the world of technology, a lot can happen within a five or ten-year lease term. Without taking sides in this struggle for market share, the restriction of uses allowed under a lease is simply one more factor to consider, one that is truly unique to medical office buildings.
Don’t Bet the Farm
Building ownership is not an all-or-nothing proposition. In fact, a commercial property can have many owners, one of which may or may not be the occupant. While a tenant is typically a business, such as a partnership or a company, it is not uncommon for some or all of the individual partners to also be owners of the building, either individually or through a separate partnership or company. Thus, savvy care-providers can have the best of both worlds by entering a lease which provides flexibility for their practice partnership and entering a separate partnership established to develop and own the building. The design of the ownership structure, and how it is capitalized, can have a profound impact upon the lease-versus-own analysis.
If building ownership is desired, then consider carefully the appropriate size of the investment. As an example, let’s consider a partnership of which four physicians are willing to develop and own the building costing $10 million. Collectively, they have a total of $2 million liquid assets available for investment. One strategy might be to form a partnership of four partners who collectively contribute their full $2 million to the partnership, which then borrows $8 million. There are a few reasons why this strategy might feel uncomfortable. The partners must place all their liquid assets into one single property, an illiquid asset with no diversification in their investment portfolio. Their lender will likely require each partner to personally guaranty the loan. An 80% loan is high leverage. The large debt service payments could put a strain on the practice, depending upon its cash flow. In short, the physicians will be 100% owners, but they will also be stretched thin financially.
An alternate strategy is to admit a fifth partner, a real estate investor which would allow the doctors to invest a smaller amount. Let’s assume the doctors invest $500,000 and their fifth partner invests $2 million. The loan amount is reduced to $7.5 million, or 75% leverage. The physicians would own no more than 20% of the building since they are investing only 20% of the total equity. However, they might sleep better. They would commit only 25% of their combined liquid assets to real estate, which is still a high allocation to one asset class, but they would leave $1.5 million, collectively, in their bank or brokerage accounts. Total leverage is reduced to 75%, which means lower debt service payments. Instead of a loan guaranty, the physicians can probably negotiate to provide a lease guaranty, instead, with each person severally guarantying 25% to 30% of the rent due. This is a much smaller personal liability. Furthermore, if their fifth partner is a professional real estate investor, then they may benefit from their experience, since all partners’ interests are aligned to maximize the value of the building.
Many hospitals and physicians have achieved successful results owning real estate. Others are content to lease space, without building ownership. There is no single right answer to fit all providers. We have discussed five major issues to consider that may help in making the right decision for your organization:
- Capital Allocation: Is this real estate investment the highest and best use of my available funds?
- Resource Allocation: Can I properly manage a building and still effectively conduct my business?
- Flexibility: Will owning my place of business create conflicts of interest that might cloud decisions regarding our future space needs?
- Control: Does my lease impose restrictions that may limit my business potential?
- Diversification: How much of my total capital should I invest in real estate? Of that how much should I place in one building?
Whether it is the CFO of a major health system, or the managing partner of a small practice, anyone contemplating the lease-versus-own decision would be well-served to answer the questions above before making the decision. If you still need a sounding board, feel free to contact the author! [email protected]