Is Your Aging Medical Facility Still Relevant?

Over the last decade, new design and construction has altered the physical characteristics and functionality of the medical building. From a healthcare systems standpoint, the motivation to renovate or build new facilities has been attributed to increased patient demand, technological advances, renewed branding efforts and access to inexpensive capital.

From a small to mid-size provider standpoint, the location attributes have been the greatest influence for continued patient demand and satisfaction. Now, larger, better capitalized systems and retailers have entered the marketplace to capture greater share of the patient marketplace.

To remain competitive, a medical facility owner and/or operator will be required to renovate or be faced with reduced patient volume within the building. Less rent, weaker leases and hemorraghing property values will be exacerbated by relentless commercial real estate up and down cycles.

In this article, we drive the debate for medical tenants and landlords to address their compelling inquires of whether to RENOVATE OR RELOCATE. Below is a progression of helpful tips that gain momentum towards relocating as the reader moves down the list.

  1. Existing structure(s) are less than 25 years old with several years of additional life remaining.
  2. The building engineering and technology infrastructure is functional with space and capacity to upgrade.
  3. Administrative and clinical space supports efficient and cost-effective operations and modern standards.
  4. There is room to increase the square footage of the user, either horizontallyBlog pic or vertically.
  5. Supportive partners or referral affiliates remain in place.
  6. The present facility offers greater opportunity than space located elsewhere.
  7. The facility is significantly dated and requires excessive capital to modernize with marginal potential return.
  8. Floor-to-ceiling heights are inadequate for modern ventilation requirements.
  9. Column spacing is too tight and inflexible for efficient space planning, particularly with planning of large diagnostic and treatment departments like imaging and surgery.
  10. Building systems such as HVAC and power are insufficient to support modern health care spaces with increased air changes and advanced imaging modalities.
  11. The facility has already been structurally maximized to remove inefficiencies. 
  12. No contiguous real estate is available for key tenants expansion.
  13. The incremental growth of old business functions causes functional inefficiencies for coordination of new programs. 
  14. Access to capital, rebranding initiatives, technology and/or increased market share will forward income generation.

For a dedicated list of factors for repurpose, redevelopment, renovation, relocation, replacement, expansion, purchase and lease representation of a medical building, contact MREA at 713.701.7900.

Leasing Vs. Owning a Medical Facility

While opinions widely differ among the ranks of healthcare providers, most would agree that the financial ramifications of long term commitments for medical real estate space will continue to weigh heavily on growth in people or technology. Some see real estate as a cost of doing business, yet, we attempt to dispute this notion and advise that it can be a tremendous avenue for personal wealth if performed with diligence and comprehension. The leasing vs. ownership model for a medical building still significantly benefits the providers seeking to purchase or development. That said, is the advantage of real estate ownership appropriate for you and your organization?

Providers, especially small to mid-size physician practices, need to answer several questions in order to determine if ownership is the right strategy going forward.

  • Will the provider own the building alone or should a joint venture with other practices be considered?
  • Will partnering with a hospital be considered?
  • Will a third-party developer or investment partner be considered to help guide the practice through the development process?
  • What are the front-end cash requirements?
  • What is the tolerance for debt guarantees?
  • How does ownership align with long-term practice strategies or goals?
  • What is a viable exit strategy?

The answers to these questions will help guide the physician group (and broker/developer/investor) to the right decision regarding equity participation in a medical office project. In today’s tight lending environment, the more cash invested, the better the borrowing terms available. Although borrowing for commercial real estate today has become increasing more challenging, especially compared to residential, we routinely take calls from lenders who will fund medical single and multi-tenant buildings by qualified buyers that will use the space.

How will the provider’s occupancy help to determine the cost of the building? Follow me here, as this is difficult for medical tenants to grasp. Rents are based on the cost of the entire project and cost of borrowed funds along with the return on cash investment desired, rather than the availability of space. In today’s medical real estate investment climate, the typical cash on annual return ranges from 9% to 15% per year based on a fully occupied building. As time lapses and rents improve, two favorable investment events happen: The cash return increases on an annual basis, and the market value of the property increases. Both of these events create increased value and wealth for their owners.

The inherent risk is the inability to maintain building occupancy with a practice group or medical rent-paying tenants. Empty buildings are extremely volatile and difficult to price. Prices parallel the availability of space coupled with the absorption of space in the regional and local marketplace. Rarely do vacant buildings increase in value unless the land underneath appreciates in value.

If you have a question regarding leasing, ownership, or simple investment into a medical building, please contact MREA at 713.701.7900.

Motivation Is Moving Medical Sublease Space

It is no secret, physicians are looking for ways to reduce expenses. Fueled by declining revenues, insurance reimbursement issues and a multitude of uncertainty, most are either downsizing their practice space or joining larger groups or systems in order to reduce the effects of less revenue and greater liabilities. If you are in a long term lease for more space than you currently require and would like to reduce your liability, then subleasing space may be the right option.

Subleasing by physicians to physicians where referral is obtained is common. In most cases, medical providers may decide to lease more space than what is needed to sublease additional space to medical providers.

It is important to note though, all subleases must independently qualify for an exception or safe harbor to Healthcare Referral Laws. The Office of Inspector General (OIG), which identifies and eliminates fraud, abuse and waste in programs administered by the Department of Health and Human Services, has issued a fraud alert which pertains to subleasing arrangements between medical providers where referral is made. Thus, it is imperative that the parties to a sublease carefully analyze and document the process by which they negotiated the rent and obtain outside support, such as rent comparables for general and sublease space in the immediate area that support the rent being charged to the sublessee.
Subleasing can be a challenging process if motivation is not present. Thus, it is important to stay focused on the objective and be competitive to achieve that objective.
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In general terms, a sublease will be considered competitive if:
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  • Two years or more remain on the lease (the shorter the term, the harder it will be to sublease without a large discount to the rent);
  • Space offered on a shared basis includes prime space (windows) in conjunction with less desirable space (interior);
  • Tenant is willing to be flexible with concessions (i.e., free rent, improvements to the space, rental abatement, furniture, equipment or shared resources in the event of shared sublease);
  • The space is presentable. If not, improvement allowances or, if shell, the ability to ‘turnkey’ a space should be ample and performed quickly.

Once you have determined that a medical space can be competitive, a proper determination of pricing should be undertaken. The pricing structure for subleasing the entire space will be different from the structure for subleasing a few offices within your space.

To price a space typically these general factors are considered:

  • The condition of the overall medical and office market;
  • Length of the remaining lease term;
  • The condition of the space (need for improvements);
  • The current lease rent and how it compares with the market;
  • Understand what the direct rents are in the building and what other sublease rents are for comparable sublease space;
  • Understand who will be in your pool of potential subtenants.
  • And, most importantly, have a qualified representative review the lease for language that may be conducive or restrictive to subleasing.

In almost all cases in today’s market, medical sublease rental rates are discounted from that of the current lease rate. Subleasing space is also a time sensitive. As time passes, the space may become less desirable and the lost income

Therefore, consider being aggressive and flexible from the outset. Be sure to havea representative price and record activity on the sublease (i.e., number of tours, number of proposals, etc.) every quarter and adjust as needed. Do not let any sublease become stagnant. Whether you are looking to sublease through shared space to vacant space, remember that the goal is to reduce the lease liability, not eliminate it.

We have included an opportunity that is for sublease in Humble, Texas. Humble Medical Office Building (Abbreviated Sublease Package – Contact MREA for Complete Offering Memorandum)

Please let MREA know how we can provide assistance for this or other healthcare real estate opportunities.

Evaluating Real Estate Options When Adding a Physician

Most physicians who are given the opportunity to join a private practice expect to eventually become partners. Typically, after a few years as an employee, physicians are provided partnership role by way of purchase opportunity. The purchase would be based upon the value of the equipment, furnishings, accounts receivable and goodwill. Most practices tend to lease their medical office space, so no value is attributable to bricks and mortar. However, some practices own the real estate and issues arise as to whether incoming physicians will be provided ownership in the real estate.

The majority of medical practices are still structured as professional corporations. Typically, if the real estate is not leased, it will not be owned by the practice corporation itself for both liability and tax reasons. Rather, the facility or condominium will be owned by a separate entity. This entity is commonly structured as either a partnership or limited liability company, or if a single doctor is involved, the real estate could be owned jointly with the doctor’s spouse. Thus, a physician may become a partner of the medical practice entity without becoming a partner of the real estate entity.

In the past, most physicians showed little interest in becoming a partner in the real estate entity, not having a true understanding of commercial real estate as an investment. Additionally, they may not have been able to produce the financial requirement for buy-in to the entity or felt the location was not suitable. Whatever the reason, it was more likely than not that an incoming physician did not consider the investment. Today, with greater access to information and investment opportunities, physicians are very interested in real estate.

Prior to being added to a practice group, it is important to know the culture and seek like strategies for ancillary or investment opportunities.  As per example, most senior physicians within the practice group may not share access to real estate ownership. Because real estate development, purchase and management is a significant investment of money (and time), it is understandable that incoming physicians would not be allowed access. Because of this, the senior physicians maintain that they will hold on to it as an investment for, or throughout, retirement. We are seeing some leeway here, though.

As an incoming physician, it would be important to take a good look at the real estate piece, no matter the situation of lease or purchase. If it is a lease, there will exist a written lease between two entities. The lease should not be above fair market value rental rate and in place for a reasonable period of time, both to be discussed further. If the rent is too high, perhaps to provide tax benefits to the owners of the real estate, there will be less capital to improve the practice. If the term is too short, you will face renegotiation of the rent too often, which will tends to create more advantage for owners that lease space. If the term is too long, the rent will likely step up each year to become a larger proportionate share of liabilities for the practice group.

In the situation of ownership, if the real estate is owned by one or more senior physicians, the practice will likely seek to relocate if they decide to sell the real estate. In order to avoid this situation, in addition to a long-term lease or a short-term lease with options to renew, the real estate owner(s) could give the non-owner practice partners an option to buy the real estate at an appraised value upon retirement or death, or a right of first refusal.
Now let’s assume that all parties wish to have an incoming physician buy in to the real estate entity. This may either occur at the time as the purchase into the practice entity or at the point the doctor has completed his or her buy-in. If the latter option is pursued, presumably, they will be more able to afford the buy-in to the real estate. In any event, the main issues will become the buy-in price and manner of payment.

The price can be determined in a few ways. One is simply by mutual agreement of all parties. Another method is simply using the original cost of the real estate if it was recently purchased, or the original cost plus annual CPI (Consumer Price Index) increases. The most common method, however, is by means of an an appraiser or broker opinion of value through appraisal or our brokerage entity. The fees could be as low as $500.

Once the price is determined, the manner of payment needs to be approached. One option is to simply pay each owner his or her share up front. If that is not possible, a promissory note could exist in favor of each real estate partner with payments made over time with interest.

A common method exists for partners to refinance the mortgage to as close to 100 percent financing as possible. The new partner would simply sign the new mortgage and be equally responsible for the debt without having to pay any out-of-pocket buy-in. The existing partners are able to pull out the cash equity at that time to realize a return on their investment. When interest rates are declining, refinancing is more likely to occur. A caveat is, if interest rates increase, the existing partners may not be willing to choose the method of refinancing due to larger interest payments, and, presumably, lesser real estate value.

Should a partner leave or retire from the medical practice, will they become obligated to sell his or her interest in the real estate and should the remaining partners be obligated to purchase his or her interest? If so, at what price? Thus, it is important to have the document treated carefully or via retainership of legal counsel.

Often times the inclusion of a physician to a practice group involves several items, including real estate, that should be addressed with business intelligence. MREA is capable of assisting in your next physician addition, partner acquisition or real estate transition. Contact your local representative for assistance.

Why Our Clients Are Saying “No” To Hospital Systems

Several years ago, a partner and I undertook a major leap of faith to become exclusively intertwined with the medical industry.  With over 40 years of combined commercial real estate experience, looking back, we took some bold steps to immerse ourselves into this growing healthcare provider network.

In the beginning, we were witnessing tremendous demand from every medical network to expand ancillary service types and locales, and imaginations were certainly running wild.  We became instant beneficiaries of this growth spurt and soaked up transactional experience and a command of the tenant mix and business components that were successful for a given medical office building or hospital system.

In just a few years, with changes occurring so rapidly, so dramatically, it is now difficult to talk ‘expansion’ with using the term ‘consolidation’ in the same sentence. This is not to say that medical groups are not expanding, it continues.   As to where, you would not be surprised.

But this time, several hospital systems have been kind enough to request our perspective on the physician marketplace and their specific growth opportunities.  Ultimately, these calls begin, and circle back to, our long standing commitment to physician groups, whereby equipping them with best potential business and real estate options in the marketplace.

But, recent dialogue suggests that hospitals are having a difficult time inducing established physician groups to become part of their system.  There are several reasons, most of which revolve around healthcare reform as a general theme, but others tend to be more specific to the physicians’ professional future and their general discontent of employment.

Thus, we want to highlight the reasons some physician groups are saying “no” to hospital employment.

1. Some hospitals are at significant risk of hiring too many doctors.  With too many doctors come too many competitive pressures for doctors to perform comfortably.

a. Doctors will need to prove their worth during the contract, especially if new groups are absorbed.  The thought alone may jeopardize physician commitment.

b. Hospitals may struggle with financial issues relative to their business plans in the mid-2000’s, or with future obligations of regulatory nature.

c. Contracts may include, sometimes discreetly, clauses that pertain to early termination.

d. Sometimes Hospitals go through mergers or acquisitions of another that has the ability to affect physician relations with one or all.

2. The intricacies of how employees should be compensated by hospital systems creates an unfair advantage from one to another.

a. Hospitals have the advantage when implementing metrics to determine the highest profitability within practice endeavors.

b. RVU methods can be abruptly changed when given the uncertainty of less or greater government support.

c. Patient increases have the ability to overwhelm certain pratice areas, such as family practice, without compensation measures that adequately provide for such increases.

3. Seniority is perceived not to be an attribute within the hospital system.

a. Hospitalists have assisted in call duty challenges, but more often than not, the younger physician population is not enthusiastic about taking a tremendous call load and are voicing their concerns.

b. Hospital systems may not provide adequate measures to control call duty and patient volume, where private practices may employ these actions.

4. Physicians are accustomed to being in control of outcomes under their supervision.

a. Physician groups are quickly implemented into system and can become disenchanted in how their doctors, or staff, are being utilized.

b. Ancillary services may be a large component of a practice’s income, in which most are absorbed or non-negotiable when entering into a hospital contract.

c. With the advent of electronic health records, comes the hospital systems consumption of physician data into the coffers of a strategic, web-based marketing and patient assimilation network.

5. Non-compete clauses could take the most highly informed physician groups by surprise, especially if contracts are for a limited period of time.

a. A Hospital system made have affiliates, or may merge or acquire another hospital or network of physicians which effectively places additional limits on where a physician, or practice, may perform.

b. Upon the conclusion of a contract or severe downturn in economy, non-compete clauses can interfere with a physician, or practice group, whereas services are no longer needed and physicians may not partner or practice where they choose.

These are just a few of basic issues that come to our attention regularly within physician discussions of Hospital employment.  Hospital systems have been fairly reactive and are tailoring their contracts to remedy such objections, but a certain stigma permeates throughout the physician public which has kept most conversations mute or placed to sidelines…for now.

Hospitals Employing Physicians: Is It Different This Time?

Around 15 years ago, physician practices were purchased by hospitals at compellingly high prices. Unfortunately for these hospital systems, within a matter of just a few years, the physicians were re-injected back into the community, largely because the hospital systems had not realized a return on investment. Fast forward to 2012, we hear similar stories about physicians becoming incorporated into a hospital’s network.
The reasons for hospital systems obtaining physician groups may be many. But, most conversations boil down to either a specialty or geographic play, whereby hospitals seek entrance or command of certain designated fields or locales. Also, with the establishment of healthcare reform, and impetus from both hospital and physicians for greater reimbursements, as well as a movement to adopt a more streamlined, technologically advanced care distribution model — we think this time may be different.
Based on casual conversations, the motivations to join a hospital from a physician perspective is appearing much greater today than it was in the mid-90′s. A weakened economy, high employment or practice costs, entry barriers, a more savvy-consumer, and the potential for declining reimbursements, are among the top justifications that we hear from physician groups.
There seems to be a greater number of differences in how the hospital systems are purchasing medical practices today, though, when compared to that of years past. Mainly, hospital systems are not offering to pay exorbitant prices, likely as a result of previous miscalculations. As for those that we speak with, many are not seeking to purchase practices outright (staff, equipment, management, real estate, in some cases). Instead, the hospital is offering employment compensation, with greater emphasis on incentives for productivity, to a select group of physicians for a number of years. Also, because reform will include greater regulatory oversight of physician purchases, this may be an incentive for hospitals to complete acquisitions prior to 2014, when the majority of reform’s initiatives take effect.

The most common way that a physician practice group is absorbed by a hospital is through a method where physician owners and practice administrators keep an ongoing operation in place, essentially subjecting to less guidelines and oversight, but to assume some naming rights, some jurisdiction, as well as partnership for likely for potential future transaction.

As for the outright sale of a practice to a hospital, it may be achieved in several different ways. A hospital may purchase a practice’s tangible assets with physicians and staff as employees of the practice, whereby the unit is obtained as a separate entity. In another instance, the hospital may acquire the assets, physicians and staff to become employees of the hospital, in which the practice discontinues. As for unique circumstances, the staff becomes employees of the hospital, but the physicians remain separate.

A certain consideration should be made by physician groups as to the value of their practice to the hospital system. Because anti-kickback laws exist, the hospital cannot pay a physician group more than ‘fair value’ for their practice. Any payment that is beyond a certain amount could be considered a ‘kickback’ for services provided to the hospital. Also, keep in mind, the revenue generated by physicians for referrals outside of the practice itself are not considered in the valuation.

Another issue that comes from a practice purchase is that physicians are not relieved of their responsibilities. This is because the acquisition is commonly considered a separate operating division or profit center of the hospital. Consequently, the physicians compensation is still tied to the profitability of their previous medical practice. This provides troublesome if physicians are nearing retirement.

One last reminder, and a stark reminder of how this time may be different, is how the practice’s patients now can easily become part of hospital’s affiliated practice, especially with the advent of electronic medical records. In essence, the hospital now owns and operates all patient lists and records that have been accumulated by the practice group.

While I will leave you with the determination of whether it is better to sell, partner or lease with a hospital, MREA has established healthcare real estate professionals, accountants and attorneys to whom you have access. Contact us for our wide range of client responsibilities that incorporate business strategies with extensive real estate capabilities.