The pros and cons of investing in real estate

March 6, 2014

Knowing when it’s the right investment can determine whether you see profit or losses from your real estate venture.

 

Marisa Manley, JDReal estate has long been a popular investment vehicle for medical professionals-from single practitioners to large practice groups.  These investments often have been motivated by tax savings, as well as by cash flow and asset appreciation.

 If the real estate you invest in is also real estate you occupy for your offices, there may also be feelings of pride, greater security, and a notion that it’s just common sense to own.  After all, as the saying goes, why pay someone else’s mortgage-the landlord’s-when you can pay your own?

Practices that invest in real estate for their own use may choose to buy or build a free-standing building that  they occupy alone or with additional space for rent-paying tenants.  A medical practice may choose a condominium in a medical office building, may become limited partners or joint venturers with experienced developers in a multi-tenanted building, or in a building that they occupy as sole tenant.  Doctors, of course, may also invest in real estate they do not occupy.

But proceed with caution. Despite common appreciation of  real estate as an investment, and the different forms an investment can take, there are good reasons for doctors not to invest in real estate.

Investing in real estate offers the potential for significant benefits: Pride of ownership, a feeling of greater security, possible tax benefits in the form of depreciation, cash flow from tenants, and increased asset value. Yet none of these benefits is assured, and there is the potential for economic loss and friction in a medical practice that may diminish the collegiality and even the viability of the practice group. 

Consider both sides of the  equation before you decide to invest in real estate. A deliberate process will most likely promote your success.

Let’s take a look at six issues every practice should consider before committing to buy real estate. We’ll focus on investments for a practice’s own needs, although many of the issues apply to every real estate investment, whether you are an owner/occupier or an off-site investor.

1. Capital intensive

Compared with leasing the space you need for your medical practice, buying real estate is always more capital-intensive. 

With leasing, a landlord funds part of your capital needs, the infrastructure and the interior build-out. When you purchase property, you must fund these needs. Even with the leverage that real estate provides, this often means that capital that could be used for equipment, software, and other enhancements to your practice competes with real estate needs. Consider which investment, real estate or practice-specific enhancements, is likely to give you the greater return. 

Younger practices, those expanding into new markets, and practices in highly competitive markets may find that capital is best deployed to buy new equipment rather than a real estate nest egg.

 

2. Real estate is not liquid, and has high transaction costs

Simply put, when you want to sell there may not be acceptable buyers.

Because each real estate parcel is unique, it must be valued as an individual unit-not as one of many fungible stocks or bonds.  The valuation you offer may not be shared by buyers. Even if you find a buyer fairly readily at an acceptable price, consider the transaction costs you will incur-most likely brokers’ fees, legal fees, and possibly some type of transfer tax.

3.  Market risk

As a real estate investor, you will be exposed to changes in the real estate market that affect the value of your investment.

These changes may relate to the demographics of a particular area, the particular use of the property, or even the obsolescence of the building or condo you are so fond of. I know of a medical practice in Virginia that spent $1 million to buy a building once occupied by pediatricians.  It had most of the infrastructure they required, but they were not able to build a sustainable practice at the location.  Several years later, they put it on the market.  Two years later it still had not sold. 

Ultimately, the practice sold the building for less than $600,000. Their assessment of what would be a good location for their practice turned out to be wrong, and while they worked through this issue, the market changed, leaving them with an asset worth far less than the amount they paid for it.

4. Management intensive

When you invest in real estate, to assure a successful investment, you must accept complex management responsibilities- maintenance, upgrades, compliance with changing building codes, and more. 

If you have tenants in your investment real estate, this will impose another set of responsibilities-avoiding vacancies, negotiating transaction terms, responding to tenant complaints, and similar responsibilities. 

Even if you hire a managing or leasing agent to handle these tasks, you must hire and manage these contractors, and ultimately, you are responsible for their performance-whether it’s code compliance or keeping tenants satisfied and your building full.  Be sure you are committed to the full-time responsibility this requires.

 

5. Conflicts of interest

In some practices, one or just a few of the partners may choose to own the real estate the practice occupies.

Such a situation can create conflicts of interest and may subject the practice to stress and friction. If the partners who own the practice want to increase the practice’s rent to reflect current market conditions, other partners may object. 

When the partners who own the real estate insist it’s time to put a new roof on the property, the non-owning partners may not see the same necessity-they may argue for a repair instead. We recently worked with a group of physicians trying to decide whether to renew a lease at their existing location or move to a new space with more contemporary amenities and closer to important referral sources. 

The partners were divided on the move. The partners who had an ownership interest in the building where the practice is now located wanted to stay.  Other partners preferred a move.  In any situation like this where some partners feel they are subsidizing the economic interests of others, the culture of the practice may suffer.

6. Exit strategy

For most real estate investments, success is determined when the property is sold or refinanced.

Medical practices investing in real estate must consider changing demographics and methods of medical practice which may affect their ability to sell at some time in the future. For example, in Manhattan, for many years, medical condos in high-end apartment buildings were sought after, and a good investment.

Recently, however, these properties have gotten harder to sell. Fewer physicians entering the market wish to practice on their own or in small groups, so the demand for these spaces is much reduced. 

In many suburban markets, office vacancy rates are high and medical practices no longer believe that they must be located in medical office buildings on or near a hospital campus.  This means that medical office space competes against a much larger group of properties in a market that favors tenants, not owners.

A physician who owns an office building in an upstate Connecticut town recently approached us for advice. In the past, she was able to fill her spaces with ease. Now, her building has been vacant for several years. She’s reluctant to invest in the building upgrades and tenant improvements that the market demands, so it’s likely that her space will remain vacant while current market conditions persist or she will have to accept lower rents and possibly tenants she finds less desirable. 

 

 

Marisa Manley is president of Healthcare Real Estate Advisors (HCREA) in New York, New York.