Monthly Archives: June 2012

Issues That Can Arise When Leasing Medical Space

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ImageYou feel fortunate to have negotiated a favorable rent on behalf of your physician group, with free rent and options to renew, a generous tenant improvement allowance, and your contractor is ready to start building out the office. You have also negotiated with your contractor a reasonable price for the tenant improvements, and you have obtained a loan from your lender to cover all of your construction costs. The landlord quickly presents you with a lease which looks to be a  well-prepared document in which he/she requests that you sign it quickly to obtain the keys to the building / space. Should you sign the lease and expedite the process or should you consult with a leasing specialist to analyze?

This article is intended to provide an overview of some of the issues that MREA encounters when negotiating leases on behalf of physician practice clients. It is not intended to be comprehensive in nature, nor is it intended to replace the advice an attorney may provide.

Commencement of Lease

Once the lease is signed, your practice group and the landlord often have objectives that differ from one another. The landlord wants the lease commenced as quickly as possible so that lease payments begin, while your office seeks the completion of the build out to the agreed specifications with everything operational.

If your landlord is building out the office space, it is of vital importance to provide the landlord with the most detailed plans relative to your space and other details in an effort to guarantee that the office will meet the groups needs and expectations. However, it is important to ensure that the lease will not commence until the built out space has passed inspection by the local building authority. Most standard form leases provide that the build out will be deemed complete when the landlord or its contractor/architect certify that it is “substantially complete”. Usually this means that “punch list” items will be completed by the contractor after you have opened for business, and this isn’t the image you want to present to your patients.

Price Increases

Nearly all leases have rent escalation clauses that are either contractual in nature or are tied to an index, usually the Consumer Price Index (CPI) published by the U.S. Department of Labor. Contractual increases are what your practice and the landlord will negotiate regarding the life of the lease term. More common is a cost of living adjustment tied to the CPI. In recent years, CPI increases have averaged approximately 2% per year. However, historically the CPI has had periods of tremendous volatility. For instance, during the four year period between 1978 and 1982, CPI increases averaged over 10% a year.

We always recommend that they have a “ceiling” on CPI increases is necessary to protect them from unusual inflation occurrences. However, this is a highly negotiable item that will not gain consideration without compromise.

Rental Rate During Option Periods

When initially negotiating the lease, your group wants the option to renew the lease, which is very specific as to rent price. If you are using the typical standard forms as provided by the landlord, you will usually find one of two standards; either an increase tied to the CPI increase over the last adjustment date or an adjustment to prevailing market rent in the area. Many business people opt for CPI increases. However, there is a hidden trap here for physicians in that they typically spend a considerable sum on tenant improvements, and the landlord knows it is simply not economical to move an office if the CPI adjustment for the option period far exceeds the prevailing market rent.

Therefore, it is important to consider an adjustment to market rent, provided that it does not restrict the rent from being reduced in a soft rental market. Also, in order to ensure that a real market rate adjustment will occur, we recommend an arbitration procedure whereby the parties each choose one appraiser, and together the two appraisers choose a third appraiser, with the two closest appraisals being averaged to determine the fair market rent. Although this procedure is rarely used, it offers protection to a physician who has an arbitrary landlord unwilling to negotiate fairly.

Office Damage

A few years ago, we received a call from a client that they had moved from an office that had been destroyed in Hurricane Ike. Although the Hurricane had occurred a year and one-half prior, the physician had received a call from the landlord telling him that the building was being renovated and the lease term was still in effect. Since the client had already built a new office in a separate location, the group found himself in a sticky situation where there was the possibility of paying on two leases.

Most of the standard physician office leases impose no real obligation for the landlord to rebuild, and provide the landlord the greatest flexibility in determining when or if to rebuild. By contrast, the tenant is typically obligated to move back into the space within a short period of time after the building is repaired. But, imagine the difficulty in retaining patients when the move into interim or new medical space is necessary, especially when unexpected. Therefore, it is becoming a common request for the right to terminate the lease if the landlord has not commenced restoration or has not completed the work within a reasonable period.

Assigning or Sublease a Space When Selling a Practice

Suppose a lease was negotiated several years prior and the lease rate is substantially below market and the current tenant remains responsible for the entire lease term plus any options. The lease also provides that the landlord can deny the assignment if it would upset the tenant mix in the building.

The landlord disapproves the assignment even though the buyer of a practice has the similar financial net worth as the seller when they signed the lease. The landlord also claims physician group’s operation would upset the tenant mix in the building, even though there were no other like physicians in the building and attempts to negotiate.

How Can You Avoid Situations Like These And Other…?

  • Eminent Domain?
  • Road Construction?
  • Tenant Becomes Disabled or Dies?
  • Foreclosure Sale?
  • Relocation Rights?
  • Water Damage?

Summary

A prospective tenant should always remember that the lease the landlord presents is subject to negotiation. The tenant should use a qualified real estate counsel to review the lease. Entering into a landlord/tenant relationship is similar to getting married, and the relationship is likely to last a long time, for better or worse. A careful review of your lease documents before signing will ensure a better relationship between your group and the landlord should issues arise.

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Medical Office Buildings: A Class Of Its Own

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Ninety-nine percent of real estate service platforms consider office and medical office one in the same. They are not. There are numerous differences between medical office space and standard office space. The most obvious are rental rates, expenses, tenant mix, construction costs, tenant improvement allowance, and building features such as elevators and parking. In addition, the proximity and the financial condition of an adjoining hospital should be examined. These examples do not even begin to touch upon the intricacies within the healthcare system itself, which is of unique consideration when purchasing a medical office building.

Medical office buildings (MOBs) are deemed “specialty use” real estate. From our perspective, many lenders will consider financing MOBs, but most lack the experience in transactions or simple dealings. Thus, identifying capable players within this asset class is critical. Whether traditional debt, fully amortized structures or even shorter term, higher leverage deals, the MOB is becoming a greater diversification tool for lenders and investors alike.

While government involvement has had a tremendous impact on the past, present and future of the healthcare industry, demographic changes that include an aging population and a increasingly informed and health conscious society is guaranteed to increase demand for years to come. Consolidation will remain a continuing trend for practice groups that lack association with stronger, more diverse physician networks and/or hospital systems. This will have a negative impact on buildings with small, not very well connected and/or aging physician groups.

As for funding, financial sponsorship remains essential to MOB transactions, especially off-campus assets. Here, owner-occupied doctor groups or hospitals themselves receive favorable underwriting treatment. The commitment to their investments and their businesses will be of tremendous importance. Of greater impact is sponsorship that features a commercial real estate firm or private equity company who joint ventures with tenants. Some of the most aggressive lending structures are dedicated to this type of partnership.

Lenders prefer on-campus MOBs, however locating and underwriting these investments can become complicated due to bond financing or land lease issues. Thus, finding the medical office property within the tight radius of the hospital might just be as easy to work, if not easier.

In terms of the lender’s perception of the development and ownership of real estate, a lot has changed after a strong run in the middle of the last decade. Healthcare is no longer deemed recession-proof and, without government support (loose term), it instead operates like the majority of for-profit businesses which became severely impacted by the credit crisis of 2008/09.

While this distinct type of investment is certainly not immune to the juggling act that is supply and demand in a highly levered world, as the economy rehabilitates, the medical office building is becoming one of the most aggressively sought after asset types within the healthcare real estate sector. Call 713-701-7900 to request assistance with one of our several MOB opportunities.