Real estate costs are one of the highest fixed expenses for most medical practices, but careful negotiating can transform rented office space into an asset.
Like their counterparts in the business world, many doctors and physician group managers tend to view their offices and practice areas primarily as a necessary but expensive venue where they can practice medicine or perform surgery or lab work.
Marisa ManleyWhile it is true real estate costs are the second- or third-highest cost category for the typical medical practice, medical office leases can be useful vehicles for managing cash flow and keeping practices healthy and profitable.
The key is negotiating with the landlord. After several years of relatively high vacancy rates for medical space, which now average around 14% nationwide, landlords are ready to play “let’s make a deal.” The point is to manage the practice’s cash flow by aligning costs with cash available. There is an advantage to doing this instead of tapping a bank credit line.
We will consider a number of strategies that can help a medical practice manage cash flow using its real estate lease. These include negotiating with the landlord to adjust the rent payments, and/or for an increased contribution to build-out costs to make a space usable for a practice. Possible strategies also include taking a smaller initial space with provisions for a later expansion, accelerating depreciation, and renewing your lease well before its expiration date.
When a practice seeks to expand to new locations, not unusual for pediatrics, orthopedics, imaging, urgent care, and other practice categories, the new locations can generally be expected to gain enough patients to break even financially in 12 to 18 months.
When that is the case, the strategy might be to negotiate a lower rent during the first months when the location is not paying its way, then increase rent once revenues will support it.
In this scenario, the practice may start at a modest $10 per square foot, and eventually increase rent with the agreement to pay interest on what was deferred. In this situation, rent at the end of the lease term may be slightly higher than market rate to compensate for the initial extra rent reductions.
This way, doctors can shift costs from the practice to the landlord during the early stages of the location’s life cycle and shift these costs back to their practice when the location becomes self-supporting. What the medical practice accomplishes in these negotiations is making its real estate transaction part of its business plan.
One practice that did this successfully is a diagnostic laboratory that was planning a new facility in a new market. The lab’s real estate adviser negotiated 12 months of rent-free occupancy, enabling the lab to build business and cash flow sheltered from a large portion of its normal expenses.
This strategy also applies to practices such as allergists that have a substantial variation in seasonal cash flow. These practices should negotiate lower rents during low-demand times and an offsetting higher rent during busy seasons.
Next: Landlords can contribute to your build-out costs
2. Increased landlord contribution to build-out costs
Another option is to negotiate with the landlord to pay for some upfront renovation costs, or for equipment or furnishings beyond the norm that can meet practice needs. Part of the process is convincing the landlord that the practice’s credit is strong. Arranging for a guarantor may help.
Often landlords make a work letter contribution to entice the tenant into the space. The negotiating objective for the medical practice is to get the landlord to contribute more-let’s say $20 additional per square foot-than the amount first offered. In this situation, the landlord makes an outright contribution to tenant costs, usually paid in cash as a reimbursement for construction costs.
Or the agreement may be for a loan toward the build-out from the landlord. For example, the additional $20 per square foot will be repaid in increased rentals at 6% interest during the latter years of the lease.
Another option is for the landlord to finance furniture and telephones, for which the tenant later repays the landlord. The landlord gets no claim on the furniture or phones. This preserves cash for use in the practice. Such arrangements are more difficult to negotiate because the money does not improve the landlord’s building; expect to be asked to show a strong track record at other locations and good prospects for cash flow.
Consider the diagnostic laboratory operator cited earlier who leased 12,000 square feet of raw space to be built out as a high-end pathology lab. The lab’s real estate adviser negotiated a substantial cash contribution from the building owner to pay for a higher-than-usual percentage of the build-out.
A large, well-established multi-site orthopedic complex sought a more efficient work-flow for doctors and for patient intake, as well as an updated image and access to more referral sources. The practice’s real estate adviser negotiated a lease that involved a move from its long-time headquarters to another location that would help them achieve these goals.
The adviser negotiated a higher cash contribution from the landlord and a longer rent-free occupancy period to defray build-out and moving costs. Negotiations included considerable work paid for by the landlord, including upgraded HVAC equipment.
Another way to achieve similar results is leasing a small space at first, with options to expand or reduce the space as the lease progresses.
The space will match current needs as they evolve. This can achieve savings similar to those of adjusting the rental payment for a constant space over the life of the lease. Be aware that any landlord will be reluctant to hold space off the market (needed for such an option) for an extended time period, and may charge a fee if you fail to exercise the option to lease additional space.
How fast can you depreciate your build-out and its component parts?
In general, commercial real estate depreciates slowly-straightline over 39.5 years. But elements of your build-out have shorter useful lives and may be depreciated more quickly: carpet may depreciate in three to five years, and ceiling tile may depreciate almost as fast.
Your practice’s accountant should examine the matter. The possibility of accelerated savings is worth investigating.
Next: Should you renew your lease early?
If you have a 10-year lease, given the present 14% vacancy rate for medical space, early renewal may be advantageous, resulting in reduced rent today in exchange for a longer commitment to remain at your current location.
Landlords are most receptive to early-renewal negotiations at about years seven or eight in a 10-year term, or possibly year three in a five-year term. The success of this strategy is highly dependent on particular conditions at the building in which you are located.
If you seek to pursue an early renewal strategy, be sure to account for savings and reductions in non-rent terms. These items may include additional free rent, a refurbishment allowance, increased landlord responsibilities for building or premises maintenance, and similar matters. Successful early renewal strategies can provide reduced costs for several years into the future.
As we have seen, practices have multiple opportunities to manage cash flow using real estate. In a tenant’s market, this advantage can be a big help to a practice.
Marisa Manley is president of Healthcare Real Estate Advisors, a nationwide real estate consulting and advisory firm located in New York, New York.